Financial market segmentation and choice of exchange rate regimes

•We study a small open economy model with segmented asset markets and financial sector shocks.•We show analytically that the state-contingent optimal monetary policy facilitates risk sharing between participants and non-participants and is countercyclical.•We compare welfare analytically across fixed and flexible exchange rate regimes.•Flexible exchange regime mimics dynamics under optimal policy and welfare dominates the fixed regime.

We study the choice of exchange rate regime in a small open economy with segmented asset markets subjected to financial sector shocks. We show that the state-contingent optimal policy facilitates risk sharing between asset market participants and non-participants, and is countercyclical. Our results establish that contrary to existing literature, flexible exchange rates mimic optimal policy and welfare dominates fixed exchange rates.