Working Paper: NBER ID: w22023
Authors: Hanno Lustig; Adrien Verdelhan
Abstract: Compared to the predictions of complete market models, actual exchange rates are puzzlingly smooth and only weakly correlated with macro-economic fundamentals, suggesting that market incompleteness plays a key role in exchange rate dynamics. Incompleteness in international financial markets introduces a stochastic wedge between the growth rates of marginal utility at home and abroad, and the change in the exchange rate. We derive a preference-free upper bound on the effects of the FX wedges. Even if domestic agents can invest only in the foreign risk-free asset, incomplete spanning fails to simultaneously match the exchange rate volatility, cyclicality and the FX risk premia in the data.
Keywords: exchange rates; incomplete markets; financial markets; stochastic discount factors
JEL Codes: F31; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| incomplete spanning in international financial markets (G15) | stochastic wedge between the growth rates of marginal utility at home and abroad (F29) |
| stochastic wedge between the growth rates of marginal utility at home and abroad (F29) | exchange rates (F31) |
| incomplete spanning in international financial markets (G15) | exchange rate volatility (F31) |
| incomplete spanning in international financial markets (G15) | correlation between macroeconomic fundamentals and exchange rate changes (F31) |