Abstract:
What do financial markets say about the exchange rate?
Not very much. We study a broad set of international financial market structures disciplined by the absence of arbitrage opportunities. In circumstances when financial markets are informative about the exchange rate, the constraints they impose on its behavior yield counterfactual implications. In contrast, financial market structures that are consistent with observed empirical properties of the exchange rate impose few constraints on its equilibrium behavior. Hence, financial markets contain nearly no information about the exchange rate resulting in financial exchange rate disconnect. Models of intermediary pricing of the exchange rate are consistent with its empirical properties, including the financial disconnect.
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