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IF-2: International Macro Finance
SONOMA: a Small Open ecoNOmy for MAcrofinance
1Bocconi University; 2Federal Reserve Board; 3Temple University, Fox School of Business, United States of America
We develop a small open production economy model in which external debt, corporate domestic debt, and risky equities coexist. Our economy features shocks to short- and long-run productivity, as well as shocks to both domestic credit conditions (Jermann and Quadrini, 2012) and global credit markets. We show that credit shocks are an important determinant of economic fluctuations in a model consistent with asset pricing facts. According to a novel empirical investigation from many small-but-developed countries, our setting features a powerful quantitative performance ideal for future monetary and fiscal policy analysis.
Sovereign Debt Ratchets and Welfare Destruction
1Copenhagen Business School; 2Stanford University; 3University of Chicago
An impatient and risk-neutral borrower can sell bonds to a more patient group of competitive lenders. The key problem: the borrower cannot commit to either a particular financing strategy, or a default strategy. In equilibrium, lending occurs, but gains from trade end up entirely dissipated, as lenders compete with each other and the borrower competes with himself. We uncover this striking result by taking a standard sovereign default model and modifying it by (i) using a government with linear preferences, and (ii) shrinking to zero the time period during which such government can commit. We show that the financing policy of the government can be computed as the ratio of (i) the wedge between the government discount rate and the return required by investors, and (ii) the semi-elasticity of the bond price function w.r.t. the debt face value. We overturn an old result of Bulow & Rogoff (1988), which argues that a borrower should never buy back his own bonds. We analyze commitment devices that allow the borrower to recapture some of the gains from trade -- sovereign debt ceilings and constant issuance policies.
A "Bad Beta, Good Beta" Anatomy of Currency Risk Premiums and Trading Strategies
UNC Charlotte, United States of America
We test a two-beta currency pricing model that features betas with risk-premium news and real-rate news of the currency market. Unconditionally, beta with risk-premium news is "bad" because of significantly positive price of risk (2.52% per annum); beta with real-rate news is "good" due to nearly zero or negative price of risk. The price of risk-premium beta risk is counter-cyclical, while the price of the real-rate beta risk is pro-cyclical. Most prevailing currency trading strategies either have excessive "bad beta" or too little "good beta," failing to deliver abnormal performance.
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