O'Reilly logo

Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

Stay ahead with the world's most comprehensive technology and business learning platform.

With Safari, you learn the way you learn best. Get unlimited access to videos, live online training, learning paths, books, tutorials, and more.

Start Free Trial

No credit card required

14.4 Models

We turn now to three general equilibrium models that through volatile SDFs can replicate the UIP puzzle and are thus consistent with the most well-known stylized facts on exchange rates. We present these models in their chronological order of appearance. Verdelhan (2010) offers the first rational expectation model of the UIP puzzle. Bansal and Shaliastovich (2008) and Colacito (2009) explain the UIP puzzle in a Bansal and Yaron's (2004) long-run risk model, and Farhi and Gabaix (2011) in a model with disaster risk.

14.4.1 Habits

We first present the general intuition for the model's mechanism, and then review a simplified version of the model that delivers key results in closed form.

Intuition

In this model, following Campbell and Cochrane (2001), the representative investor has external habit preferences over consumption. In bad times, when consumption is close to the habit level and investors are more risk-averse, risk-free rates are low. In this case, UIP fails just as it does in the data. What is the intuition for this result? When markets are complete, the real exchange rate, measured in units of domestic goods per foreign good, equals the ratio of foreign to domestic pricing kernels—cf. Equation 14.1. Exchange rates thus depend on foreign and consumption growth shocks. If the conditional variance of the domestic SDF is large relative to its foreign counterpart, then domestic consumption growth shocks determine variations in exchange rates. When the domestic economy ...

With Safari, you learn the way you learn best. Get unlimited access to videos, live online training, learning paths, books, interactive tutorials, and more.

Start Free Trial

No credit card required