Volatility, intermediaries, and exchange rates

Xiang Fang and Yang Liu ()

Journal of Financial Economics, 2021, vol. 141, issue 1, 217-233

Abstract: We propose and estimate a quantitative model of exchange rates in which participants in the foreign exchange market are intermediaries subject to value-at-risk (VaR) constraints. Higher volatility translates into tighter VaR constraints, and intermediaries require higher returns to hold foreign assets. Therefore, the foreign currency is expected to appreciate. The model quantitatively resolves the Backus–Smith puzzle, the forward premium puzzle, and the exchange rate volatility puzzle and explains deviations from the covered interest rate parity. Moreover, the model implies both contemporaneous and predictive relations between proxies of leverage constraint tightness and exchange rates. These implications are supported in the data.

Keywords: Volatility; Financial intermediaries; Exchange rates; Currency returns; Value at Risk (search for similar items in EconPapers)
JEL-codes: F31 G15 G20 (search for similar items in EconPapers)
Date: 2021
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0304405X21000891
Full text for ScienceDirect subscribers only

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:141:y:2021:i:1:p:217-233

DOI: 10.1016/j.jfineco.2020.05.010

Access Statistics for this article

Journal of Financial Economics is currently edited by G. William Schwert

More articles in Journal of Financial Economics from Elsevier
Bibliographic data for series maintained by Catherine Liu ().