Working Paper: CEPR ID: DP17334
Authors: Magnus Dahlquist; Christian Heyerdahl-Larsen; Anna Pavlova; Julien Penasse
Abstract: In periods of global stress, there are large movements in exchange rates and asset prices. Currencies of developed economies appreciate, with the US dollar appreciating the most. Global stock markets fall, but the US market falls by less. While the external balance sheet of the US is riskier and its net foreign assets fall, this effect is overturned by the dollar appreciation, resulting in a wealth transfer to the US. To rationalize these facts, we build a general equilibrium model with time-varying risk appetites that produces asymmetric portfolios. Richer countries have more appetite for risk, levering up their external portfolios by borrowing from poorer countries. Consequently, their net foreign assets fall in periods of stress, yet there is a wealth transfer from poor to rich countries due to currency appreciations. The model delivers time-varying currency risk premia, matches key asset pricing moments, and produces realistic external portfolios.
Keywords: currency risk premium; habit formation; net foreign assets; wealth transfers
JEL Codes: E43; F31; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| US dollar appreciation (F31) | decline in net foreign assets (NFA) (F32) |
| US dollar appreciation (F31) | wealth transfer to the US (H87) |
| decline in net foreign assets (NFA) (F32) | relative wealth of the US increases (D31) |
| wealth transfer to the US (H87) | US stock market falls less than foreign markets (G15) |
| time-varying risk appetites (G40) | wealth transfer from poorer to richer nations (F16) |
| US dollar appreciation (F31) | reversal of expected wealth transfer direction (G51) |
| US investors' home bias (F21) | US dollar appreciation (F31) |
| currency risk premiums (F31) | asset pricing moments (G19) |