Incomplete Asset Market View of the Exchange Rate Determination

60 Pages Posted: 12 Dec 2016 Last revised: 4 Mar 2018

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: March 1, 2018

Abstract

We completely characterize the fundamental relationship between the exchange rate and the asset pricing in the two denomination currencies involved when markets are incomplete. Assuming arbitrage-free, perfectly integrated, frictionless but potentially incomplete financial markets, the exchange rate is equal to the ratio of countries' minimum-variance stochastic discount factors if and only if every exchange rate risk can be separately contracted in asset markets, i.e., exchange rate risks are completely disentangled. Abstracting from structural assumptions, the entanglement of exchange rate risks presents a novel and pure market-based rationale for a disconnection between prices and quantities in the international economy. Our study demonstrates when and how the influential asset market view of the exchange rate does not pose strong implications from the exchange rate dynamics on the macroeconomic fundamentals and their pricing.

Keywords: Exchange Rates, Incomplete Markets, Risk Entanglement, International Correlations, Asset Market View

JEL Classification: F31, G15, G10

Suggested Citation

Maurer, Thomas Andreas and Tran, Ngoc-Khanh, Incomplete Asset Market View of the Exchange Rate Determination (March 1, 2018). Available at SSRN: https://ssrn.com/abstract=2883890 or http://dx.doi.org/10.2139/ssrn.2883890

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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