International SDFs in Segmented Markets∗

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 necessary to jointly reconcile well-known exchange rate puzzles, including the low exchange rate volatility, the exchange rate cyclicality and deviations from uncovered interest rate parity. At the same time, segmented stock markets are needed to avoid implausibly large SDF dispersions. These findings demonstrate a trade-off between financial market segmentation, SDF variability and the amount of tradeable exchange rate risk when addressing international asset pricing puzzles.