Asset Pricing with Incomplete Information In a Discrete Time Pure Exchange Economy

We study the consumption based asset pricing model in a discrete time pure exchange setting with incomplete information. Incomplete information leads to a filtering problem which agents solve using the Kalman filter. We characterize the solution to the asset pricing problem in such a setting. Empirical estimation with US consumption data indicates strong statistical support for the incomplete information model versus the benchmark complete information model. We investigate the ability of the model to replicate some key stylized facts about US equity and riskfree returns.asset pricing, incomplete information, Kalman filter, equity returns, riskfree returns

Incomplete information processing: a solution to the forward discount puzzle

The uncovered interest rate parity equation is the cornerstone of most models in international macro. However, this equation does not hold empirically since the forward discount, or interest rate differential, is negatively related to the subsequent change in the exchange rate. This forward discount puzzle implies that excess returns on foreign currency investments are predictable. In this paper we investigate to what extent incomplete information processing can explain this puzzle. We consider two types of incompleteness: infrequent and partial information processing. We calibrate a two-country general equilibrium model to the data and show that incomplete information processing can fully match the empirical evidence. It can also account for several related empirical phenomena, including that of "delayed overshooting." We show that incomplete information processing is consistent both with evidence that little capital is devoted to actively managing short-term currency positions and with a small welfare gain from active portfolio management. The gain is small because exchange rate changes are very hard to predict. The welfare gain is easily outweighed by a small cost of active portfolio management.Foreign exchange

A Framework for Identifying the Sources of Local-Currency Price Stability with an Empirical Application

The inertia of the local-currency prices of traded goods in the face of exchange-rate changes is a well-documented phenomenon in International Economics. This paper develops a framework for identifying the sources of local-currency price stability. The empirical approach exploits manufacturers’ and retailers’ first-order conditions in conjunction with detailed information on the frequency of price adjustments in response to exchange-rate changes, in order to quantify the relative importance of markup adjustment by manufacturers and retailers, local-cost non-traded components, and nominal price rigidities, in the incomplete transmission of exchange-rate changes to prices. The approach is applied to micro data from the beer market. We find that on average, 54.1% of the incomplete exchange rate pass-through is due to local non-traded costs; 33.7% to markup adjustment; and 12.2% to the existence of price adjustment costs.currency prices, exchange rates

A Structural Approach to Identifying the Sources of Local-Currency Price Stability

The inertia of the local-currency prices of traded goods in the face of exchange-rate changes is a well-documented phenomenon in International Economics. This paper develops a structural model to identify the sources of this local-currency price stability and applies it to micro data from the beer market. The empirical procedure exploits manufacturers’ and retailers’ first-order conditions in conjunction with detailed information on the frequency of price adjustments following exchange-rate changes to quantify the relative importance of local non-traded cost components, markup adjustment by manufacturers and retailers, and nominal price rigidities in the incomplete transmission of such changes to prices. We find that, on average, approximately 60% of the incomplete exchange rate pass-through is due to local non-traded costs; 8% to markup adjustment; 30% to the existence of own-brand price adjustment costs, and 1% to the indirect/strategic effect of such costs, though these results vary considerably across individual brands according to their market shares.

FX trading and Exchange Rate Dynamics

This paper provides new perspective on the poor performance of exchange rate models by focusing on the information structure of FX trading. I present a new theoretical model of FX trading that emphasizes the role of incomplete and heterogeneous information. The model shows how an equilibrium distribution of FX transaction prices and orders can arise at each point in time from the optimal trading decisions of dealers. This result motivates empirical investigation of how the equilibrium distribution of FX prices behaves using a new data set that details trading activity in the FX market. This analysis produces two striking results: (i) Much of the observed short-term volatility in exchange rates comes from sampling the heterogeneous trading decisions of dealers in an equilibrium distribution that, under normal market conditions, changes comparatively slowly. (ii) In contrast to the assumptions of traditional macro models, public news is rarely the predominant source of exchange rate movements over any horizon.Foreign Exchange, Trading, Microstructure

Exchange Rate Fundamentals and Order Flow (July 2004)

This paper addresses the striking ability of transaction flows to explain exchange rate movements. Specifically, we examine whether this arises because transaction flows convey incremental information about fundamentals. If so, then these flows should affect price upon their realization and observation by price setters (marketmakers). Our model is a simple general equilibrium model of information aggregation that provides---in a setting of incomplete markets---a utility-based present-value representation for exchange rates. The model produces testable implications for the relationships between realized transaction flows, current and future exchange rate returns, and future fundamentals (e.g., money supplies). We then bring these implications to the data, making use of a new dataset covering over six years of transactions (which permits estimation at the monthly frequency). We find strong contemporanous effects of transaction flows on exchange rates, corroborating past findings. More importantly, we present four key findings that are both new to the literature and supportive of our model: (1) transaction flows forecast (Granger cause) future macroeconomic variables such as money growth, output growth, and inflation, (2) transaction flows forecast future exchange rates changes, and do so more effectively than forward discounts, (3) the future exchange rate components that current flows forecast are primarily the future non-flow-driven components, and (4) though flows convey new information about future fundamentals, much of this information is still not impounded in the exchange rate 9 months later. The slow pace of learning implies that abstracting from information aggregation---as is standard in exchange rate economics---is not innocuous.Exchange Rate Dynamics, Microstructure, Order Flow.

Household heterogeneity and real exchange rates

Typical incomplete markets models in international economics make two assumptions. First, households are not able to fully insure themselves against country-specific shocks. Second, there is a representative household within each country, so that households are fully insured against idiosyncratic shocks. We assume instead that cross-household risk-sharing is limited within countries, but cross-country risk-sharing is complete. We consider two types of limited risk-sharing: domestically incomplete markets (DI) and private information-Pareto optimal (PIPO) risk-sharing. We show that the models imply distinct restrictions between the cross-sectional distributions of consumption and real exchange rates. We evaluate these restrictions using household-level consumption data from the United States and the United Kingdom. We show that the PIPO restriction fits the data well when households have a coefficient of relative risk aversion of around 5. The analogous restrictions implied by the representative agent model and the DI model are rejected at conventional levels of significance.Markets

Asset prices and exchange rates: a time dependent approach

This paper studies the relationship between exchange rates and asset prices. It takes the novel approach of modeling both the markets in a framework of heterogeneous agents. Investors maximize their profits from the international equity markets by solving a Mean-Variance problem. As a result, agents choose between different combinations of rules in the home and foreign equity market as well as in the foreign exchange market. Given the incomplete information setting, agents check the past profitability of their rules and switch behavior in the effort to maximize their profits. Due to the heuristics embedded within the model, this simple frame-work alone is able to create a complex, time-varying dynamics. This dynamics is analyzed for different parameters and conditions. Finally the model is brought to the data, to check the fitness of the predictions on the real world markets.Behavioral finance, exchange rates, asset prices