With Tarek A. Hassan and Thomas M. Mertens.
[Slides]
Abstract:
Canonical long-run risk and habit models reconcile high equity premia with smooth risk-free rates by inducing an inverse functional relationship between the variance and the mean of the stochastic discount factor. We show this highly successful resolution to closed-economy asset pricing puzzles is fundamentally problematic when applied to open economies with complete markets: It requires that differences in currency returns arise almost exclusively from predictable appreciations, not from interest rate differentials. In the data, by contrast, exchange rates are largely unpredictable and currency returns differ because interest rates differ widely across currencies. We show that no complete-markets model with canonical long-run risk and habit preferences can match this fact. We argue this tension between canonical asset pricing and international macroeconomic models is a key reason why researchers have struggled to reconcile the observed behavior of exchange rates, interest rates, and capital flows across countries. The lack of such a unifying model is a major impediment to understanding the effect of risk premia on international markets.