Research Discussion Paper – RDP 8610 Equilibrium Exchange Rates and a Popular Model of International Asset Demands: An Inconsistency
July 1986
Abstract
Many of the continous time Ito process models of international asset demand deal with the simplest case of geometric Brownian motion processes for asset prices and exchange rates. Following the single country models, these international models yield restrictions on the moments of the price processes via the solution of asset market clearing conditions. This produces an International Capital Asset Pricing model, but it does not also deliver restrictions on the exchange rate processes. This paper shows that consideration of associated equilibrium conditions in the foreign exchange markets (which are inherent in the international version of the model) produces such restrictions, allowing full pricing of assets in the various currencies and exchange rates. However, it is also shown that the assumption of geometric Brownian motion for exchange rates is inconsistent with these restrictions. This suggests the need for further work to impose the additional equilibrium constraints in models with more flexible price processes.