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Asset prices and real exchange rates with deep habits

Journal

Review of Financial Studies

Subject

Finance

Authors / Editors

Heyerdahl-Larsen C

Publication Year

2014

Abstract

I study a two-country, two-good pure-exchange economy with deep habits and consumption home bias. The model jointly accounts for the volatility of the real exchange rate, equity premiums, stock return volatilities and the levels and volatilities of the risk free rates. I show that the model with deep habits can simultaneously produce an upward-sloping real yield curve and the failure of the uncovered interest rate parity. Both the volatility of the real exchange rate and the equity premium depend on habit formation, but load dierently on the preference parameters. While the equity premium mainly depends on risk aversion, the real exchange rate depends mostly on the elasticity of substitution between the home and foreign good. I illustrate that consumption home bias in traded goods leads to a portfolio home bias.

Keywords

Asset Pricing Moments; Real Exchange Rates; Multi-Good Economies; Deep

Available on ECCH

No


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