Volatility, Intermediaries and Exchange Rates

• DOI: 10.2139/ssrn.2872904
• Publication Date: 2016-11-30T16:00:43Z
• Authors: Yang Liu; Xiang Fang
• Keywords: Intermediary

We propose and estimate a quantitative model of exchange rates in which participants the foreign market are intermediaries subject to value-at-risk (VaR) constraints. Higher volatility translates into tighter VaR constraints, require higher returnsto hold assets. Therefore, currency is expected appreciate. The quantitatively resolves Backus-Smith puzzle, forward premium rate puzzle explains deviations from covered interest parity. Moreover,the implies both contemporaneous predictive relations between proxies leverage constraint tightness rates. These implications supported data.