14. Exchange Rates in a Stochastic Discount Factor Framework

  1. Jessica James,
  2. Ian W. Marsh4 and
  3. Lucio Sarno4,5
  1. Hanno Lustig1,2 and
  2. Adrien Verdelhan2,3

Published Online: 8 OCT 2012

DOI: 10.1002/9781118445785.ch14

Handbook of Exchange Rates

Handbook of Exchange Rates

How to Cite

Lustig, H. and Verdelhan, A. (2012) Exchange Rates in a Stochastic Discount Factor Framework, in Handbook of Exchange Rates (eds J. James, I. W. Marsh and L. Sarno), John Wiley & Sons, Inc., Hoboken, NJ, USA. doi: 10.1002/9781118445785.ch14

Editor Information

  1. 4

    Cass Business School, London, UK

  2. 5

    CEPR, UK

Author Information

  1. 1

    UCLA Anderson School of Management, Los Angeles, CA, USA

  2. 2

    NBER, USA

  3. 3

    Department of Finance, MIT Sloan School of Management, Cambridge, MA, USA

Publication History

  1. Published Online: 8 OCT 2012
  2. Published Print: 14 JUN 2012

ISBN Information

Print ISBN: 9780470768839

Online ISBN: 9781118445785

SEARCH

Keywords:

  • currency portfolios;
  • exchange rates;
  • stochastic discount factor (SDF);
  • uncovered interest rate parity (UIP) regressions

Summary

According to the uncovered interest rate parity (UIP) condition, expected changes in exchange rates should be equal to the interest rate differentials between foreign and domestic risk-free bonds. This chapter surveys empirical and theoretical risk-based approaches of exchange rates. It starts by laying down the basic theoretical framework, defining stochastic discount factors (SDFs) (also known as pricing kernels or intertemporal marginal rates of substitution) and exchange rates from a financial perspective. Then, the chapter reviews the recent body of empirical evidence emerging from this financial approach of exchange rates. Along this line, it describes a key methodological innovation, that is, the use of currency portfolios, and then turns to recent findings on exchange rates based on this new method. Finally, the chapter reviews the general equilibrium models that are consistent with stylized facts on currency markets.

Controlled Vocabulary Terms

currency portfolios; exchange rates; stochastic discount factor (SDF); uncovered interest rate parity