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  5. Does Incomplete Spanning in International Financial Markets Help to Explain Exchange Rates?

Does Incomplete Spanning in International Financial Markets Help to Explain Exchange Rates?

  • Hanno Lustig
  • Adrien Verdelhan
American Economic Review
vol. 109, no. 6, June 2019
(pp. 2208-44)
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Abstract

We assume that domestic (foreign) agents, when investing abroad, can only trade in the foreign (domestic) risk-free rates. In a preference-free environment, we derive the exchange rate volatility and risk premia in any such incomplete spanning model, as well as a measure of exchange rate cyclicality. We find that incomplete spanning lowers the volatility of exchange rate, increases the risk premia but only by creating exchange rate predictability, and does not affect the exchange rate cyclicality.

Citation

Lustig, Hanno, and Adrien Verdelhan. 2019. "Does Incomplete Spanning in International Financial Markets Help to Explain Exchange Rates?" American Economic Review, 109 (6): 2208-44. DOI: 10.1257/aer.20160409

Additional Materials

JEL Classification

  • E32 Business Fluctuations; Cycles
  • F31 Foreign Exchange
  • F44 International Business Cycles
  • G15 International Financial Markets