Incomplete Asset Market View of the Exchange Rate Determination

We completely characterize the fundamental relationship between the exchange rate and the asset pricing in the two denomination currencies involved when markets are incomplete. Assuming arbitrage-free, perfectly integrated, frictionless but potentially incomplete financial markets, the exchange rate is equal to the ratio of countries' minimum-variance stochastic discount factors if and only if every exchange rate risk can be separately contracted in asset markets, i.e., exchange rate risks are completely disentangled. Abstracting from structural assumptions, the entanglement of exchange rate risks presents a novel and pure market-based rationale for a disconnection between prices and quantities in the international economy. Our study demonstrates when and how the influential asset market view of the exchange rate does not pose strong implications from the exchange rate dynamics on the macroeconomic fundamentals and their pricing