Entangled risks in incomplete FX markets

Thomas Maurer and Ngoc-Khanh Tran

Journal of Financial Economics, 2021, vol. 142, issue 1, 146-165

Abstract: We introduce the concept of risk entanglement in a preference-free setting to jointly explain the exchange rate volatility, cyclicality, and currency risk premia in the data. Risk entanglement specifies a subset of incomplete market models, in which nondiffusive or nonlog-normal shocks to exchange rates are not fully spanned by asset returns. When risks are entangled, there exist multiple pricing-consistent exchange rates, but none of them are equal to the ratio of the stochastic discount factors (SDFs) or their projections. Decoupling the exchange rate from the SDFs allows us to address key FX market patterns that are puzzling in international finance.

Keywords: Exchange rates; International finance puzzles; Entangled risks; Jump risks; Incomplete markets (search for similar items in EconPapers)
JEL-codes: F31 G12 G15 (search for similar items in EconPapers)
Date: 2021
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:142:y:2021:i:1:p:146-165

DOI: 10.1016/j.jfineco.2021.05.051

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