« Back to Results

Exchange Rate Puzzles

Paper Session

Sunday, Jan. 5, 2020 8:00 AM - 10:00 AM (PDT)

Manchester Grand Hyatt, Cortez Hill B
Hosted By: Econometric Society
  • Chair: Nikolai Roussanov, University of Pennsylvania

Puzzling Exchange Rate Dynamics and Delayed Portfolio Adjustment

Philippe Bacchetta
University of Lausanne
Eric van Wincoop
University of Virginia


The objective of this paper is to show that the proposal by Froot and Thaler (1990) of delayed portfolio adjustment can account for a broad set of puzzles about the relationship between interest rates and exchange rates. The puzzles include: i) the delayed overshooting puzzle; ii) the forward discount puzzle (or Fama puzzle); iii) the predictability reversal puzzle; iv) the Engel puzzle (high interest rate currencies are stronger than implied by UIP); v) the forward guidance exchange rate puzzle; vi) the absence of a forward discount puzzle with long-term bonds. These results are derived analytically in a simple two-country model with portfolio adjustment costs. Quantitatively, this approach can match all targeted moments related to these puzzles.

Financial Dollarization in Emerging Markets: An Insurance Arrangement

Husnu Dalgic
University of Mannheim


Households in emerging markets hold significant amounts of dollar deposits while firms have significant amounts of dollar debt. Motivated by the perceived dangers, policymakers often develop regulations to limit dollarization. In this paper, I draw attention to an important benefit of dollarization, which should be taken into account when crafting regulations. I argue that dollarization serves as an insurance arrangement in which firms provide income insurance to households in exchange of low cost of borrowing. Emerging market exchange rates tend to depreciate in recessions so that households prefer holding deposits denominated in dollars, as an insurance against economic downturns. They effectively starve local financial markets of local currency, which raises local interest rates and causes entrepreneurs to borrow in dollars. Consistent with my argument, countries in which the exchange rate depreciates in recessions have higher levels of deposit and credit dollarization and the premium of the local interest rate over the dollar interest rate is higher. This premium is the price paid by households for insurance.

Volatility, Intermediaries, and Exchange Rates

Xiang Fang
University of Pennsylvania
Yang Liu
University of Hong Kong


This paper studies how time-varying volatility drives exchange rates through financial intermediaries’
risk management. We propose a model where currency market participants are
levered intermediaries subject to value-at-risk constraints. Higher volatility translates into tighter
financial constraints. Therefore, intermediaries require higher returns to hold foreign assets,
and the foreign currency is expected to appreciate. Estimated by the simulated method
of moments, our model quantitatively resolves the Backus-Smith puzzle, the forward premium
puzzle, the exchange rate volatility puzzle, and generate deviations from covered interest rate
parity. Our empirical tests verify model implications that volatility and financial constraint
tightness predict exchange rates.

The Non-U.S. Bank Demand for U.S. Dollar Assets

Tobias Adrian
International Monetary Fund
Peichu Xie
International Monetary Fund


The USD asset share of non-U.S. banks captures the demand for dollar by these marginal investors. An instrumental variable strategy identifies a causal link from the USD asset share to the USD exchange rate. Cross-sectional asset pricing tests show the USD asset share to be a highly significant pricing factor for carry trade strategies. The USD asset share forecasts the dollar with economically large magnitude and high statistical significance, both in sample and out of sample, pointing towards time varying risk premia. Contemporaneous exchange rate variations due to demand shocks revert over 2-5 years as risk premia normalize.
Adrien Verdelhan
Massachusetts Institute of Technology
Lorena Keller
University of Pennsylvania
Luigi Bocola
Stanford University
Wenxin Du
University of Chicago
JEL Classifications
  • G1 - General Financial Markets
  • F3 - International Finance