Currency Premia and Global Imbalances

Abstract

This is the accepted version of the paper.This version of the publication may differ from the final published version. Permanent repository link Currency Premia and Global ImbalancesFirst version: February 2014 -Revised: January 2016 AbstractWe show that a global imbalance risk factor that captures the spread in countries'external imbalances and their propensity to issue external liabilities in foreign currency explains the cross-sectional variation in currency excess returns. The economic intuition is simple: net debtor countries o¤er a currency risk premium to compensate investors willing to …nance negative external imbalances because their currencies depreciate in bad times. This mechanism is consistent with exchange rate theory based on capital ‡ows in imperfect …nancial markets.We also …nd that the global imbalance factor is priced in cross sections of other major asset markets.

An Incomplete Markets Explanation of the Uncovered Interest Rate Parity Puzzle

“…The mechanism generating the time‐varying risk premium matches very well the empirical findings of Della Corte et al (). These authors investigate the role of large outstanding external asset and liability positions in generating a time‐varying risk premium that can account for failure of UIP.…”

“…The model's risk premium is greater the larger a country's outstanding external position, because of increasingly stronger precautionary motives of avoiding binding liquidity constraints. The main mechanism of the theoretical model is therefore consistent with recent empirical findings of Della Corte et al (), who find that a currency becomes risky when it exposes investors to the risk of excessive debt, as reflected in large external positions.…”

“…The generated premium drives a wedge between the interest rate differential and expected exchange rate changes, thereby significantly lowering the coefficient in a UIP regression. The paper thus documents the existence of a novel and, as documented in Della Corte et al (), empirically relevant channel in explaining deviations from UIP. Also, despite the model's reliance on standard preferences and shock processes, it manages to go a long way in rationalizing the observed negative UIP regression coefficients found in the data.…”

“…Verdelhan (2010), Bansal and Shaliastovich (2013), and Colacito and Croce (2013) address the UIP puzzle in frameworks of non-standard preferences combined with particular shock dynamics, typically in a setting of complete markets. To my knowledge, this paper is one of the first to theoretically address the UIP puzzle through a link of the currency risk premium with a country's external position (another recent contribution is Gabaix and Maggiori (2015))-which is of empirical relevance, as recently documented in Della Corte et al (2014). In a related paper, Leduc (2002) explores the implications of borrowing constraints in the two-country monetary model of Lucas (1982), with aggregate and idiosyncratic uncertainty.…”