Abstract
We resolve a long-standing quest to unite the dynamics of the exchange rate with that of country-specific pricing by establishing a necessary and sufficient condition for their unity. Assuming arbitrage-free and perfectly integrated international financial markets, the exchange rate is equal to the ratio of countries' stochastic discount factor projectors if and only if every exchange rate risk is singly traded in markets, i.e., exchange rate risks are completely disentangled. Therefore, exchange rate risk entanglement presents a novel conceptual rationale for the observed perplexing disconnection between the levels of international risk sharing implied by prices (smooth exchange rates) and by quantities data (low cross-country consumption correlations). Our study completely characterizes when and how the influential asset market view of the exchange rate does not pose strong implications on the exchange rate dynamics.
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