DP13252 International yield curves and currency puzzles

Author(s): Mikhail Chernov, Drew Creal
Publication Date: October 2018
Date Revised: January 2019
Keyword(s): affine models, bond valuation, Exchange Rates, FX disconnect
JEL(s): F31, G12, G15
Programme Areas: Financial Economics, International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13252

The depreciation rate is often computed as the ratio of foreign and domestic pricing kernels. Using bond prices alone to estimate these kernels leads to currency puzzles: the inability of models to match violations of uncovered interest parity and the volatility of exchange rates. That happens because of the FX bond disconnect, the inability of bonds to span exchange rates. This view of the puzzles is distinct from market incompleteness. Incorporating exchange rates into estimation of yield curve models helps with resolving the puzzles. That approach also allows one to relate the cross-country differences between international yields to currency risk premiums.