Risk Aversion, Financial Stress and Their Non-Linear Impact on Exchange Rates

Tomas Adam, Soňa Benecká and Jakub Matějů

Working Papers from Czech National Bank, Research and Statistics Department

Abstract: This paper shows how the reaction of selected emerging CEE currencies to increased uncertainty depends on market sentiment in a core advanced economy or even on the global scale. On the example of the Czech koruna, a highly stylized model of portfolio allocation between EUR- and CZK-denominated assets suggests the presence of two regimes characterized by different reactions of the exchange rate to increased stress in the euro area. The "diversification" regime is characterized by appreciation of the koruna in reaction to an increase in the expected variance of EUR assets, while in the "flight to safety" regime, the koruna depreciates in response to increased variance. We suggest that the switch between regimes may be related to changes in risk aversion, driven by the actual level of strains in the financial system as captured by financial stress indicators. Using the Bayesian Markov-switching VAR model, the presence of these regimes is identified in the case of the Czech koruna and to a lesser extent in the case of the Polish zloty and the Hungarian forint. We find that a slight increase in euro area financial stress causes the koruna to appreciate, but as financial market tensions intensify (and investors’ risk aversion increases), the Czech currency depreciates in response to a financial stress shock.

Keywords: Asset allocation; exchange rates; financial stress; Markov-switching (search for similar items in EconPapers)
JEL-codes: E44 F31 G12 G20 (search for similar items in EconPapers)
Date: 2014-09
New Economics Papers: this item is included in nep-mac, nep-opm and nep-tra
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:cnb:wpaper:2014/07

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