Entangled Risks in Incomplete FX Markets
51 Pages Posted: 2 Dec 2015 Last revised: 13 Dec 2016
Date Written: December 12, 2016
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: Suggested Citation