A general equilibrium model for exchange rates and asset prices in an economy subject to jump-diffusion uncertainty

This dissertation examines asset prices, the exchange rate and its higher moment properties in an economy subject to both diffusive and jump risk. The model used in this dissertation is an extension of Zapatero's (1995) two-good two-country intertemporal international equilibrium model for two logarithmic representative agents. Uncertainty enters the economy through a three dimensional Brownian motion and two Poisson processes representing positive and negative jumps in the dividend process of the goods. Individual financial markets are incomplete, but all claims can be hedged completely in the international financial market. From Zapatero's (1995) model it is known that the exchange rate increases with the interest rate differential and the diffusion parameter of the domestic equity market and decreases with the covariance between the domestic and foreign equity market. This dissertation shows that in a jump-diffusion setting the expected equilibrium exchange rate change additionally increases (decreases), if the foreign positive and negative jump sizes are bigger (smaller) in absolute value than their domestic equivalents. This dissertation thereby provides a new explanation for the interest rate parity puzzle. It is a well-known empirical fact that exchange rates are skewed and have excess kurtosis. In contrast to traditional equilibrium models subject to diffusive risk the exchange rate return exhibits these two properties in the jump-diffusion setting. The sign of the skewness of the exchange rate return is dependent on the difference between the skewness of the returns of the domestic and foreign dividend processes.