| dc.description |
This paper develops a simple two-country, two-good model, in which the real
exchange rate, stock and bond prices are jointly determined. The model predicts that
stock market prices are correlated internationally even though their dividend processes
are independent, providing a theoretical argument in favor of financial contagion. The
foreign exchange market serves as a propagation channel from one stock market to
the other. The model identifies interconnections between stock, bond and foreign
exchange markets and characterizes their joint dynamics as a three-factor model.
Contemporaneous responses of each market to changes in the factors are shown to
have unambiguous signs. These implications enjoy strong empirical support. Estimation
of various versions of the model reveals that most of the signs predicted by the model
indeed obtain in the data, and the point estimates are in line with the implications of our
theory. Furthermore, the uncovered interest rate parity relationship has a risk premium
term in our model, shown to be volatile. We also derive agents' portfolio holdings and
identify economic environments under which they exhibit a home bias, and
demonstrate that an international CAPM obtaining in our model has two additional
factor |
|