This dissertation explores the determination of asset prices in the world through a low-dimensional set of risk factors. The economic intuition driving this work comes from the idea that investors form their future expectations on the economy based on observable risk patterns that determine the price of assets today. Given that those risk factors are summarized in current prices, studying the dynamics of interest rates at different horizons provides information on the market’s expectations of future macroeconomic fundamentals. I provide a summary of the literature that investigates asset pricing dynamics through term structure models.
After analyzing the empirical applications of the yield curve and extracting the underlying factors that drive different assets and macroeconomic fundamentals, I pose the question: Can interest rate factors explain exchange rate fluctuations? In other words, is the information summarized in the yield curve enough to account for movements in the exchange rates? To answer this question, I expand a canonical no-arbitrage factor model of the term structure, in which the yields for the domestic and the foreign countries are determined by their own interest rate factors, and the ratio of their stochastic discount factors determines the (log) exchange rate changes, as predicted by the theory. My results suggest that yield curves do contain important information to determine exchange rates, and potentially other asset prices, particularly at longer horizons. Moreover, extracting three or more factors from the yield curves (characterized as level, slope, and curvature) significantly improves the fit of the model. The information content in the yield curve can also account for the Uncovered Interest Parity puzzle, suggesting that financial markets contain information on the exchange rate risk premium. I also explore the ability of European countries to predict the path of the euro/U.S. dollar exchange rate with their own country specific factors. The results suggest that yield curve factors from many European countries have explanatory power over the euro dynamics. This work has important implications for understanding theoretical and empirical connections between interest rates and exchange rates through term structure models.