UiS Business School Seminar: Production-Based Exchange Rates

Abstract:

The paper starts by documenting a novel empirical fact, foreign currencies appreciate in the future (with respect to the U.S. dollar) upon larger capital investment rates of foreign subsidiaries of U.S. firms. I examine the link between bilateral exchange rates and the real economy in a multi-country investment-based asset pricing model. I show that the well-known equivalence between stock returns and investment returns is only a special case of a cross-border investment model that allows for the determination of exchange rate fluctuations. In the model, real investment adjustment costs abroad and at home are key determinants of investment return differentials. Higher foreign affiliate investment rates capture higher underlying investment opportunities abroad, and in turn higher Tobin's Q-differentials between the foreign affiliate and the U.S. headquarter. Going forward, the foreign currency appreciates against the U.S. dollar to offset the higher marginal benefits of production abroad relative to at home. I explore the testable implications of the model in a structural estimation framework using Generalized Method of Moments (GMM). The model does well in accounting for mean excess returns to currency carry trade portfolios.

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Meeting ID: 697 3579 8999

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