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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 among 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. Moreover, the factors we extract from daily data on stock indexes and
exchange rates explain a sizable fraction of the variation in a number of macroeconomic variables, and the estimated
signs on the factors are consistent with our model's implications. 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 factors. |
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