Make SDFs Great Again

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We characterize international stochastic discount factors (SDFs) under various degrees of market segmentation in a preference-free approach. Our methodology minimizes SDF dispersion subject to international pricing constraints and allows for a factorization into permanent and transitory components. We find that large permanent SDF components are key to jointly reconcile well-known exchange rate puzzles, including the low exchange rate volatility, the exchange rate cyclicality and the deviations from UIP. At the same time, segmented stock markets are needed to avoid implausibly large SDF dispersions. These findings reflect a key trade-off between financial market segmentation, SDF variability and the amount of tradeable exchange rate risk when addressing international asset pricing puzzles.

Author(s):

Paula Mirela Sandulescu    
University of Lugano & Swiss Finance Institute
Switzerland

Fabio Trojani    
University of Geneva & Swiss Finance Institute
Switzerland

Andrea Vedolin    
London School of Economics
United Kingdom