Model-Free International Stochastic Discount Factors

Abstract

We provide a theoretical framework to uncover in a model-free way the relationship between international stochastic discount factors (SDFs), stochastic wedges, and financial market structures. Exchange rates are in general different from the ratio of international SDFs in incomplete markets, as captured by a stochastic wedge. We theoretically show that this wedge can be zero in incomplete and integrated markets. Market segmentation breaks the strong link between exchange rates and international SDFs, which helps address salient features of international asset returns, while keeping the volatility and cross-country correlation of SDFs at moderate levels.

Keywords: stochastic discount factor, exchange rates, market segmentation, financial intermediaries

JEL Classification: F31, G12