Working Paper: CEPR ID: DP12971
Authors: Paula Mirela Sandulescu; Fabio Trojani; Andrea Vedolin
Abstract: We provide a theoretical characterization of international stochastic discount factors (SDFs) in incomplete markets under different degrees of market segmentation. Using 40 years of data on a cross-section of countries, we estimate model-free SDFs and factorize them into permanent and transitory components. We find that large permanent SDF components help to reconcile the low exchange rate volatility, the exchange rate cyclicality, and the forward premium anomaly. However, integrated markets entail highly volatile and almost perfectly comoving international SDFs. In contrast, segmented markets can generate less volatile and more dissimilar SDFs. In quest of relating the SDFs to economic fundamentals, we document strong links between proxies of financial intermediaries’ risk-bearing capacity and model-free international SDFs. We interpret this evidence through the lens of an economy with two building blocks: limited participation by households and financiers who face an intermediation friction.
Keywords: stochastic discount factor; exchange rates; market segmentation; market incompleteness; financial intermediaries
JEL Codes: F31; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| large permanent SDF components (Y80) | exchange rate behavior (F31) |
| market segmentation (M31) | SDF behavior (C69) |
| integrated markets (F02) | SDF correlation (C10) |
| proxies of financial intermediaries' risk-bearing capacity (G21) | modelfree international SDFs (C59) |
| market segmentation (M31) | deviations from asset market view (G19) |