International Yield Curves and Currency Puzzles

The currency depreciation rate is often computed as the ratio of foreign to domestic pricing kernels. Using bond prices alone to estimate these kernels leads to currency puzzles: the inability of models to match violations of uncovered interest parity and the volatility of exchange rates. This happens because of the FX bond disconnect, the inability of bonds to span exchange rates. Incorporating innovations to the pricing kernel that affect exchange rates but not bonds helps resolve the puzzles. This approach also allows one to relate news about cross-country differences between international yields to news about currency risk premiums.

Automated summary

The currency depreciation rate is often calculated as the ratio of foreign to domestic pricing kernels. However, using only bond prices to estimate these kernels leads to currency puzzles, where models fail to explain violations of uncovered interest parity and exchange rate volatility. The FX bond disconnect, which refers to the inability of bonds to cover exchange rates, is the main cause of these puzzles. By incorporating innovations to the pricing kernel that affect exchange rates but not bonds, these puzzles can be resolved. This approach also allows for the explanation of news about cross-country differences in international yields and currency risk premiums.