Asset Prices and Exchange Rates

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.