Implications of Incomplete Markets for International Economies

Abstract

We develop a restriction that precludes implausibly high reward-for-risk in incomplete international economies to consider a theoretical problem that characterizes a lower bound on the covariance between stochastic discount factors (SDFs) subject to correct pricing. The problem is analytically solvable and synthesizes domestic and foreign SDFs into spanned and unspanned components. Our novelty is that exchange rate growth need not equal the ratio of SDFs and that the SDF correlations are plausibly lowered. Exploiting realities of cross-country correlations of macroeconomic quantities, namely, consumption, wealth, dividend growths, and asset returns, our empirical investigation refutes the specification of complete markets.

Keywords: Incomplete Markets, Exchange Rates

JEL Classification: F31, G12, G15