Template-Type: ReDIF-Paper 1.0
Author-Name: Boris Hofmann
Author-X-Name-First: Boris
Author-X-Name-Last: Hofmann
Author-Name: Ilhyock Shim
Author-X-Name-First: Ilhyock
Author-X-Name-Last: Shim
Author-Name: Hyun Song Shin
Author-X-Name-First: Hyun Song
Author-X-Name-Last: Shin
Title: Risk capacity, portfolio choice and exchange rates
Abstract: We assess how swings in exchange rates affect global bond investors' portfolio allocations to emerging market economy (EME) local currency bonds based on a portfolio choice model and empirical analyses using granular security-level bond spread data and fund-level bond flow data. We lay out a portfolio choice model in which swings in exchange rates can affect investors' risk-taking capacity in a Value-at-Risk framework. Exchange rate fluctuations induce shifts in portfolio holdings of global investors even in the absence of currency mismatches on the part of the borrowers and in particular when they are broadly common across EMEs rather than idiosyncratic. Empirical evidence from granular security-level bond spread and fund-level bond flow data supports the predictions of the model. An appreciation of an EME currency against the US dollar increases bond fund inflows and reduces bond spreads. The effect is considerably stronger when the appreciation is broad-based, as captured by the broad US dollar index, than when it is idiosyncratic.
Length: 37 pages
Creation-Date: 2022-07
File-URL: https://www.bis.org/publ/work1031.pdf
File-Format: Application/pdf
File-Function: Full PDF document
File-URL: https://www.bis.org/publ/work1031.htm
File-Format: text/html
Number: 1031
Keywords: bond spread, capital flow, credit risk, emerging market, exchange rate
Classification-JEL: G12, G15, G23
Handle: RePEc:bis:biswps:1031