Implications of Incomplete Markets for International Economies

Gurdip Bakshi, Mario Cerrato and John Crosby

The Review of Financial Studies, 2018, vol. 31, issue 10, 4017-4062

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 the 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. Received September 19, 2016; editorial decision August 31, 2017 by Editor Andrew Karolyi. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Date: 2018
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