Does Incomplete Spanning in International Financial Markets Help to Explain Exchange Rates?

65 Pages Posted: 1 Mar 2016 Last revised: 6 Mar 2022

See all articles by Hanno N. Lustig

Hanno N. Lustig

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Adrien Verdelhan

National Bureau of Economic Research (NBER); Massachusetts Institute of Technology (MIT) - Sloan School of Management

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Date Written: February 2016

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.

Suggested Citation

Lustig, Hanno N. and Verdelhan, Adrien and Verdelhan, Adrien, Does Incomplete Spanning in International Financial Markets Help to Explain Exchange Rates? (February 2016). NBER Working Paper No. w22023, Available at SSRN: https://ssrn.com/abstract=2739549

Hanno N. Lustig (Contact Author)

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Adrien Verdelhan

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