A Uni ed Theory of Bond and Currency Markets

I show that an external habit model augmented with a heteroskedastic consumption growth process reproduces main domestic and international bond market puzzles, considered di cult to replicate simultaneously. Domestically, the model generates an upward sloping real yield curve and realistic violations of the expectation hypothesis. Depending on the parameters, the model can also generate a downward sloping real yield curve and predicts that the expectation hypothesis violations are stronger in countries with upward sloping real yield curves. Internationally, the model explains violations of the uncovered interest rate parity. Unlike a standard habit model, the model simultaneously features intertemporal smoothing to match domestic term structure and precautionary savings to reproduce international predictability. The model also replicates the imperfect correlation between consumption and bond prices/exchange rates through positive and negative consumption shocks a ecting habit di erently. Mechanisms of the model are empirically supported.