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

74 Pages Posted: 13 May 2015 Last revised: 17 Dec 2018

See all articles by Hanno N. Lustig

Hanno N. Lustig

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

Adrien Verdelhan

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

Multiple version iconThere are 2 versions of this paper

Date Written: January 1, 2018

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: currency risk, exchange rates, market incompleteness

JEL Classification: F31, F41, E44

Suggested Citation

Lustig, Hanno N. and Verdelhan, Adrien, Does Incomplete Spanning in International Financial Markets Help to Explain Exchange Rates? (January 1, 2018). American Economic Review, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2604792 or http://dx.doi.org/10.2139/ssrn.2604792

Hanno N. Lustig (Contact Author)

Stanford Graduate School of Business ( email )

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Adrien Verdelhan

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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Cambridge, MA 02142
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National Bureau of Economic Research (NBER) ( email )

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