Why Are Countries Asset Portfolios Exposed To Nominal Exchange Rates PDF Download

My dissertation studies the determinants of the currency composition of assets and liabilities of governments, private agents, and the aggregate economy and the macroeconomic consequence of foreign currency exposure. This first chapter documents that emerging market sovereigns still borrow substantially in foreign currency and borrow even more when the exchange rate (FX) volatility is higher, precisely when it is riskier for them to do so. This paper builds a quantitative sovereign default model with a risk-averse sovereign and risk-averse international investors, where the optimal currency composition of external sovereign borrowing is the outcome of a risk-sharing problem between the borrower and lenders. Emerging economies choose to bear FX risk and borrow in foreign currency because international investors charge a high FX risk premium on emerging market local currency debt. Moreover, the required risk premium on local currency debt is higher when FX volatility increases, further dissuading emerging economies from borrowing in local currency. The estimated model with high risk aversion of lenders quantitatively matches well the foreign exchange risk premium, the relative borrowing cost in local currency over foreign currency, and the currency composition of external public debt. The model also performs well quantitatively in accounting for positive comovements between (i) the foreign currency share of external public debt and exchange rate volatility, and (ii) the relative borrowing cost in local currency over foreign currency and exchange rate volatility. A counterfactual exercise shows that exchange rate stabilization results in a welfare gain to the emerging market sovereign of 0.35\% measured in consumption equivalents. The second chapter helps unravel the long-standing equity home bias puzzle by building a model in which an agent infrequently adjusts her portfolio holdings of home and foreign equities. As real exchange rate returns are volatile, an investor who invests in foreign equities and holds on to her portfolio holdings for a long duration is likely to drift away from an optimal allocation. The agent, taking infrequent adjustment into account ex-ante, lowers her demand for foreign equities, generating home bias in equities. The introduction of the euro into various European countries and the enlargement of euro area in subsequent years provide a natural environment in which to validate the implications of the model. We empirically document that European countries experience lower equity home bias after adopting the euro as cross-border equity investment within the euro area entails no nominal exchange rate risk. When the levels of real exchange rate volatility are calibrated to match the average levels for European countries in the euro area and outside the euro area, the model can match the difference in levels of equity home bias between European countries experienced after the introduction of the euro. In the third chapter (joint with Junhyong Kim), with a novel dataset that combines Korean firm-level and industry-level data, we explore a balance sheet channel through which an exchange rate shock translates into domestic producer prices. Exploiting a large devaluation episode in Korea in 1997, we document that a sector with higher foreign currency debt exposure prior to the crisis experienced a larger price increase. Building a heterogeneous firm model with working capital and financial constraints, we study the transition path upon unexpected exchange rate depreciation. Upon unexpected depreciation, firms with high foreign currency debt exposure face tighter working capital and financial constraints, which reduces investment and increases costs of production and prices. The model matches qualitatively and quantitatively the observed marginal effect of the short-term foreign currency debt ratio on the sectoral price changes. The model with the balance sheet channel only can explain around 17% of the variation in price changes during the crisis. We also find that the interaction of strategic complementarity in firms' price setting and heterogeneity in foreign currency debt holdings across firms within an industry play an important role in amplifying the price increase.