Risk capacity, portfolio choice and exchange rates

Boris Hofmann, Ilhyock Shim and Hyun Song Shin

No 1031, BIS Working Papers from Bank for International Settlements

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.

Keywords: bond spread; capital flow; credit risk; emerging market; exchange rate (search for similar items in EconPapers)
JEL-codes: G12 G15 G23 (search for similar items in EconPapers)
Pages: 37 pages
Date: 2022-07
New Economics Papers: this item is included in nep-ban, nep-ifn, nep-mon and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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