DP15337 The Global Factor Structure of Exchange Rates

Author(s): Sofonias Alemu Korsaye, Fabio Trojani, Andrea Vedolin
Publication Date: October 2020
Keyword(s): Capital Flows, factor models, Financial Frictions, incomplete markets, International Asset Pricing, Lasso, Market Segmentation, regularization, Stochastic discount factor
JEL(s): F31, G15
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15337

We provide a model-free framework to study the global factor structure of exchange rates. To this end, we propose a new methodology to estimate international stochastic discount factors (SDFs) that jointly price cross-sections of international assets, such as stocks, bonds, and currencies, in the presence of frictions. We theoretically establish a two-factor representation for the cross-section of international SDFs, consisting of one global and one local factor, which is independent of the currency denomination. We show that our two-factor specification prices a large cross-section of international asset returns, not just in- but also out-of-sample with R2s of up to 80%.