Model-free international stochastic discount factors

AuthorF. Trojani, M. Sandelescu, A. Vedolin
JournalThe Journal of Finance
Date25 March 2021
CategoryAcademic Publications
Volume76(2)
Page numbers935–976

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.