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RFS Advance Access originally published online on January 29, 2007
Review of Financial Studies 2007 20(4):1139-1180; doi:10.1093/revfin/hhm008
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Copyright © The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies.

Asset Prices and Exchange Rates

Anna Pavlova
London Business School and CEPR

Roberto Rigobon
Sloan School of Management, MIT, and NBER

Address correspondence to Roberto Rigobon, Sloan School of Management, MIT, 50 Memorial Drive, E52-431, Cambridge, MA 02142-1347, or e-mail: rigobon{at}mit.edu

JEL: G12, G15, F31, F36


  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.

We thank Cam Harvey (the editor) and three anonymous referees for valuable suggestions which led to a substantial improvement of the article. We also thank Mark Aguiar, Suleyman Basak, Olivier Blanchard, Hoyt Bleakley, Dave Cass, Phil Dybvig, Mike Gallmeyer, John Geanakoplos, Burton Hollifield, Leonid Kogan, Jun Pan, Bob Pindyck, Hélène Rey, Nouriel Roubini, Pedro Santa-Clara, Tom Stoker, Chris Telmer, Raman Uppal, Dimitri Vayanos, and seminar participants at the AFA meetings, Bank of England, Boston College, City, Columbia, LBS, MIT, NBER Asset Pricing meetings, NBER Summer Institute (IFM Group), Maryland, Pennsylvania, Rutgers, Texas at Austin, UCLA, USC, WFA meetings, Wisconsin, and Yale for useful comments. Pavitra Kumar provided excellent research assistance. All remaining errors are ours.


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