Working Paper: CEPR ID: DP17454
Authors: Ester Faia; Juliana Salomao; Alexia Ventula Veghazy
Abstract: With a unique dataset of euro area corporate bonds we study the role of large heterogeneous investors’ demand on currency pricing. We docu- ment that while insurance and pension funds exhibit strong preferences for holding assets issued by local firms and denominated in home currency; mutual funds do not. Motivated by this segmentation, we estimate the impact of investor demand on euro-dollar return differentials (hedged and unhedged) for given security and issuer. These differentials decline as ECB asset purchases induce a drain in euro securities. A dynamic portfolio optimization model of bonds in different currencies, where heterogeneous risk-attitudes lead to UIP deviations and regulation to CIP ones, accounts for the facts.
Keywords: Heterogeneous mandates; Large investors; Market segmentation; Securities; Data uncovered and covered interest rate parity; Scarcity channel; Risk rebalance channel; Asset safety
JEL Codes: F3; G2; G4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| demand from large institutional investors (ICPF) (G23) | eurodollar yield differential (E43) |
| ECB asset purchases (E52) | scarcity of euro-denominated securities (G15) |
| scarcity of euro-denominated securities (G15) | increase in their valuation (G19) |
| scarcity of euro-denominated securities (G15) | decrease in required return for such securities (G12) |
| decline in risk (at longer maturities) (G33) | rebalance toward euro-denominated securities (G15) |
| investor demand (G19) | pricing of euro-denominated securities (G15) |