Model-Free International Stochastic Discount Factors

Model-free SDFs in international financial markets characterize exchange rate puzzles under different assumptions on financial market segmentation

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Publicationdate

  • 04/02/2021

Publisher

  • with M. Sandulescu and A. Vedolin | Journal of Finance, Volume 76, Issue 2, Pages 935-976, 2021

Category

  • Publications

Website

Astract

We provide a theoretical framework to uncover in a model‐free way the relationships among international stochastic discount factors (SDFs), stochastic wedges, and financial market structures. Exchange rates are in general different from the ratio of international SDFs in incomplete markets, as captured by a stochastic wedge. We show theoretically that this wedge can be zero in incomplete and integrated markets. Market segmentation breaks the strong link between exchange rates and international SDFs, which helps address salient features of international asset returns while keeping the volatility and cross‐country correlation of SDFs at moderate levels.