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Entangled Risks in Incomplete FX Markets

51 Pages Posted: 2 Dec 2015 Last revised: 13 Dec 2016

Thomas Andreas Maurer

Washington University in St. Louis - John M. Olin Business School; London School of Economics & Political Science (LSE)

Ngoc-Khanh Tran

Washington University in Saint Louis - John M. Olin Business School

Date Written: December 12, 2016

Abstract

We study the implications of risk entanglements on international financial (FX) markets. Risk entanglement is a refinement of incomplete markets that some risks in asset markets cannot be singly traded. We show that in FX markets with entangled risks (i) there exist multiple pricing-consistent exchange rates, (ii) every exchange rate is affected by idiosyncratic risks, and (iii) exchange rates can be smooth while stochastic discount factors (SDFs) are volatile and almost uncorrelated. These results are in stark contrast to the case of complete markets or incomplete markets without risk entanglements.

Keywords: Incomplete Markets, Exchange Rate, Entangled Risks, Jump Risks, International Correlation Puzzle

JEL Classification: F31, G15, G10

Suggested Citation

Maurer, Thomas Andreas and Tran, Ngoc-Khanh, Entangled Risks in Incomplete FX Markets (December 12, 2016). Available at SSRN: https://ssrn.com/abstract=2697278

Thomas Andreas Maurer

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Ngoc-Khanh Tran (Contact Author)

Washington University in Saint Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

HOME PAGE: http://www.olin.wustl.edu/EN-US/Faculty-Research/Faculty/Pages/FacultyDetail.aspx?username=ntran

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