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BIS-1: Exchange Rates and Financial Conditions
Intermediary Leverage and Currency Risk Premium
University of Pennsylvania, United States of America
This paper proposes an intermediary-based explanation of the risk premium of currency carry trade in a model with a cross-section of small open economies. In the model, bankers in each country lever up and hold interest-free cash as liquid assets against funding shocks. Countries set different nominal interest rates, while low interest rates encourage bankers to take high leverage. Consequently, bankers' wealth drops sharply with a negative shock. This reduces foreign asset demand and leads to a domestic appreciation, which in turn makes low-interest-rate currencies good hedges. The model implies covered interest rate parity deviations when safe assets differ in liquidity. The empirical evidence is consistent with the main model implications: (i) Low-interest-rate countries have high bank leverage and low currency returns; (ii) the carry trade return is procyclical with a positive exposure to the bank stock return; and (iii) comovement of the carry trade return and the stock return increases with the stock market volatility.
Exchange Rate Exposure and Firm Dynamics
1University of Minnesota, United States of America; 2University of Warwick
This paper develops a heterogeneous firm-dynamics model with endogenous currency debt composition to jointly study financing and investment decisions in developing economies. In our model, firms' foreign currency borrowing arises from a trade-off between exposure to currency risk and growth. We assess econometrically the pattern of foreign currency borrowing using firm-level census data on Hungary, calibrate the model and quantify its aggregate impact. Our counterfactual exercises show that foreign currency borrowing can lead to higher growth and that the efficiency of the banking sector to screen productive and capital-scarce firms is essential to reap up the benefits of this financing.
US Fiscal Cycle and the Dollar
Kellogg School of Management, Northwestern University, United States of America
I document a new pattern unique to the US: When the US fiscal condition is strong, the dollar is strong and continues to appreciate against foreign currencies in the next 3 years. A no-arbitrage model replicates this pattern, provided that the US fiscal cycle comoves with the dollar's risk premium. This model further predicts that the US fiscal cycle explains the forward premium puzzle, the term premium, the dollar carry trade, and currency return momentum, all confirmed in the data. What makes this fiscal-currency comovement unique to the US? I highlight its exceptional external balance sheet and its special role as the hegemon issuer of the world's reserve assets as contributing factors, and provide suggestive evidence from cross-border capital flows and official foreign reserves.
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