We introduce convenience yields on dollar bonds into an incomplete-markets equilibrium model of exchange rates and interest rates. The convenience yield enters as a stochastic wedge in the Euler equation for exchange rate determination. The model identifies a novel safe-asset convenience yield channel by which quantitative easing impacts the dollar exchange rate. Our model addresses three exchange rate puzzles:
- The model can rationalize the low pass-through of SDF shocks to exchange rates.
- It helps address but does not fully resolve the exchange rate disconnect puzzle.
- The model generates an unconditional log currency risk premium on the dollar that is in line with the data.