Asset Prices and Exchange Rates

TLDR

Trade in goods creates an additional international propagation channel via terms of trade, absent from traditional single‑good models. The study examines how adding demand shocks and trade in goods alters a standard international asset‑pricing model. The model is solved in closed form, yielding a system of equations that can be empirically estimated. Including demand shocks overturns unrealistic implications of models that rely solely on productivity shocks, generates rich predictions about the co‑movement of stocks, bonds, and foreign exchange markets, and is validated by empirical estimation.

Abstract

We study the implications of introducing demand shocks and trade in goods into an otherwise standard international asset pricing model. Trade in goods gives rise to an additional channel of international propagation—through the terms of trade—absent in traditional single-good models. The inclusion of demand shocks helps overturn many unrealistic implications of existing international finance models in which productivity shocks are the sole source of uncertainty. Our model generates a rich set of implications on how stock, bond, and foreign exchange markets co-move. We solve the model in closed-form, which yields a system of equations that can be readily estimated empirically. Our estimation validates the main predictions of the theory.