Working Papers

A Currency Premium Puzzle

With Tarek A. Hassan and Thomas M. Mertens. Draft coming soon.
Abstract: Canonical long-run risk and habit models address the equity premium puzzle by inducing a strong, negative correlation between the variance and the mean of the stochastic discount factor. When applied to an open economy with complete markets, this key feature requires that differences in currency returns should arise primarily from predictable appreciations, a requirement that is at odds with the data. We term this tension between a high equity premium, smooth risk-free rates, and largely unpredictable exchange rates the currency premium puzzle and argue it is the underlying reason why existing international asset pricing models have struggled to simultaneously match data on currency returns, equity returns, and risk-free rates.

Currency Premium and Capital Accumulation

Job Market Paper
Abstract: There are large and persistent differences in capital-output ratios across countries, suggesting capital is not flowing to countries where it is relatively scarce, a phenomenon often referred to as the "Lucas Paradox". In the data, capital-output ratios vary a lot even within developed countries and they are negatively correlated with currency premia and risk-free rates. To rationalize these patterns, I build a quantitative multi-country model of capital accumulation with external habit and heterogenous exposures to a global shock. I show that currency risk induced by these heterogenous exposures, which is widely used to rationalize currency premia and risk-free rates, can generate cross-country variations in capital-output ratios that is quantitatively consistent with the data when complemented with external habit. I estimate the model using GDP data from countries issuing the G10 currencies and make two main findings: (1) the heterogenous loadings that I extract from only GDP data are highly correlated with capital-output ratios; (2) when I feed the estimated loadings to the model, model generated capital-output ratios account for roughly 55% of the cross-country variations in the data.