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Entangled risks in incomplete FX markets

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  • Maurer, Thomas
  • Tran, Ngoc-Khanh

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.

Suggested Citation

  • Maurer, Thomas & Tran, Ngoc-Khanh, 2021. "Entangled risks in incomplete FX markets," Journal of Financial Economics, Elsevier, vol. 142(1), pages 146-165.
  • Handle: RePEc:eee:jfinec:v:142:y:2021:i:1:p:146-165
    DOI: 10.1016/j.jfineco.2021.05.051
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    More about this item

    Keywords

    Exchange rates; International finance puzzles; Entangled risks; Jump risks; Incomplete markets;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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