Market Incompleteness and Exchange Rate Spill-over
Financial variables in third countries explain a significant fraction of bilateral exchange rate movements, even after local variables and common factors are controlled for. This paper proposes an explanation of this exchange rate spill-over pattern based on market incompleteness, which arises when agents in different countries bear different exposures to foreign risks, while the asset space is not complete enough to hedge out these risks. This mechanism weakens the link between exchange rates and local fundamentals, and generates additional exchange rate variations and comovements. To study bilateral exchange rates, it is not sufficient to consider only the local conditions.
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