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

65 Pages Posted: 1 Mar 2016 Last revised: 6 Mar 2021

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: 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, 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)

Stanford Graduate School of Business ( email )

Stanford GSB
655 Knight Way
Stanford, CA California 94305-6072
United States
3108716532 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Adrien Verdelhan

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

100 Main Street
E62-416
Cambridge, MA 02142
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
25
Abstract Views
483
PlumX Metrics