Inefficient Financial Markets and Volatile Currency Values
In a groundbreaking study, economists Emile A. Marin and Sanjay R. Singh have proposed a novel solution to the long-standing Backus-Smith puzzle, the mystery surrounding the countercyclical behavior of exchange rates. Their paper, titled "Incomplete Markets and Exchange Rates," published as Federal Reserve Bank of San Francisco Working Paper 2025-11, suggests that incomplete markets and imperfect risk-sharing within countries play significant roles in explaining this phenomenon.
The researchers explain that for reconciliation of exchange rates to occur, exchange rates must be sufficiently risky with respect to idiosyncratic states. In a two-country setting, imperfect risk-sharing within countries can reconcile the aggregate cyclicality of exchange rates, addressing the Backus-Smith puzzle.
The mechanism linking imperfect risk-sharing and exchange rate dynamics works by allowing individual agents to face varying exposure to idiosyncratic risks. This results in discount factor heterogeneity and "discount factor wedges." These wedges help reconcile the aggregate cyclicality of exchange rates with observed data patterns.
Moreover, market incompleteness plays distinct roles within and across countries. While international financial incompleteness alone cannot change the sign of the Backus-Smith covariance, adding domestic incomplete markets and heterogeneity among agents enables generating the negative correlation observed empirically.
In equilibrium, a country experiencing higher consumption growth must have relatively elevated idiosyncratic risk. This elevated risk translates into a risk premium for exchange rates, affecting their cyclicality.
The study provides direct empirical support for this mechanism by identifying measurable discount factor wedges associated with imperfect domestic risk-sharing. The analysis focuses on household-level data, offering a granular perspective on the role of idiosyncratic risk and heterogeneity within countries.
The paper measures discount factor wedges, capturing the effects of imperfect risk sharing, and offers valuable insights into the intricate relationship between incomplete markets, imperfect risk-sharing, and exchange rate dynamics. The study can be accessed at the link: Incomplete Markets and Exchange Rates.
This research sheds light on the complex interplay between markets, risk, and exchange rates, offering a fresh perspective on the Backus-Smith puzzle and the role of incomplete markets and imperfect risk-sharing within countries.
Businesses in two different countries can experience imperfect risk-sharing, which can reconcile the cyclicality of exchange rates, according to a novel solution proposed by economists Emile A. Marin and Sanjay R. Singh. The researchers suggest that this imperfect risk-sharing, combined with market incompleteness, can help explain the countercyclical behavior of exchange rates that has long puzzled economists, as outlined in their paper titled "Incomplete Markets and Exchange Rates."
