Macroeconomic Fundamentals and the Exchange Rate Dynamics: A No-Arbitrage Macro-Finance Approach

This paper investigates the relationship between the exchange rate dynamics and macroeconomic fundamentals by proposing an arbitrage-free stochastic discount factor model that jointly prices bond yields and exchange rates. Based on empirical analysis using data on exchange rates, yields of zero-coupon bonds, and macroeconomic variables of the US and the Euro area, the paper finds a close link between macroeconomic fundamentals and the exchange rate dynamics. The model-implied monthly exchange rate changes can explain about 57% variation of the observed data. The macroeconomic innovations can help capture large volatility of exchange rate changes, and the foreign exchange risk premium can largely alleviate the forward premium anomaly.