The Multiplicative Wedge Approach to Incomplete Markets and the Trifecta of Exchange Rate Puzzles

32 Pages Posted: 24 Sep 2016 Last revised: 1 Nov 2016

See all articles by Gurdip Bakshi

Gurdip Bakshi

Fox School of Business

John Crosby

University of Maryland - Robert H. Smith School of Business

Date Written: October 6, 2016

Abstract

In international economies with incomplete markets, the multiplicative wedge approach of Backus, Foresi, and Telmer (2001) encapsulates the idea that log exchange rate growth deviates from log relative of the stochastic discount factors by a perturbation. We analyze the asset pricing implications of this approach in the context of the trifecta of exchange rate puzzles, with three results. First, we analytically show that the currency risk premium is detached from the multiplicative wedge perturbation. This key result is both distribution-free and preference-free and implies that the approach cannot resolve the forward premium puzzle. Moreover, it is not feasible to reproduce the low unconditional volatility of exchange rate growth with realistic parameterizations. Finally, the slope coefficient in the Backus and Smith regression is not affected by the perturbation.

Keywords: currency puzzles, incomplete spanning, multiplicative wedge

Suggested Citation

Bakshi, Gurdip S. and Crosby, John, The Multiplicative Wedge Approach to Incomplete Markets and the Trifecta of Exchange Rate Puzzles (October 6, 2016). Available at SSRN: https://ssrn.com/abstract=2837461 or http://dx.doi.org/10.2139/ssrn.2837461

Gurdip S. Bakshi (Contact Author)

Fox School of Business ( email )

Department of Finance
Philadelphia, PA 19022
United States
215-204-6117 (Phone)
tuk40718@temple.edu (Fax)

HOME PAGE: http://https://sites.google.com/view/gurdipbakshi1

John Crosby

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States
+447979901892 (Phone)

HOME PAGE: http://www.john-crosby.co.uk/

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