Interpreting global factor compositions economically via investor portfolios
Professor Fabio Trojani, Sofonias Alemu Korsaye (2023 GSEM Ph.D. Graduate), and Andrea Vedolin (Questrom School of Business, Boston University) have co-authored an article that develops a model-free theoretical framework to identify a global asset pricing factor. Published in the Journal of Financial Economics, their findings indicate that across different market structures and frictions, the factor structure of international stochastic discount factors (SDFs) can be approximated by a single global asset pricing factor. Therefore, almost all cross-sectional variation in exchange rates can be described by one global factor, which is independent of currency denomination and strongly linked to intermediary constraints.
We propose a model-free methodology to estimate international stochastic discount factors (SDFs) that jointly price cross-sections of international stocks, bonds, and currencies in markets with frictions. We theoretically establish a SDF decomposition into one global factor and a currency basket. We show that our global factor prices a large cross-section of international asset returns, not just in- but also out-of-sample, across different currency denominations. Moreover, the pricing ability of the global factor is largely independent of the market structure or the size and type of market friction.
Access the study: The Global Factor Structure of Exchange Rates
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August 22, 2023