Exchange Rates and Asset Prices in a Global Demand System

The paper develops an asset demand system to analyze, jointly and across all countries, how international portfolio holdings and flows, exchange rates, short-term rates, long-term yields, and equity prices are determined in equilibrium. The authors specify a nested logit model of asset demand (substitution across countries within an asset class, and across asset classes) and introduce a new instrumental-variables identification strategy based on the size distribution of countries and bilateral distances; estimating on portfolio-holdings data for 37 countries and three asset classes from 2003 to 2020, they find demand is relatively inelastic, with mean demand elasticities of 27.9 (s.e. 1.9) for short-term debt, 3.2 (0.4) for long-term debt, and 1.2 (1.1) for equity. A variance decomposition attributes 82% of exchange-rate variation, 86% of short-term-rate variation, and 60% of log market-to-book equity variation to ’latent demand’ (the residual demand shifter), while portfolio flows (54%) and macro variables (43%) dominate long-term yields. Applying the framework to the European sovereign debt crisis, latent demand explains essentially all of the Italian long-term-yield variation and 74% of the Portuguese, whereas macro fundamentals are relatively more important for Greece (46% vs. 32% for latent demand), which the authors read as consistent with Greece being insolvent while Italy and Portugal were solvent but perceived as vulnerable. Estimating the convenience yield on US assets, they find, in units of expected annual returns, 1.41% on the US dollar, 2.71% on US long-term debt, and 0.50% on US equity. All estimates are specific to their sample, model, and identification assumptions.

Ralph S.J. Koijen | Macro Paper Warehouse

Exchange Rates and Asset Prices in a Global Demand System