Working Paper: CEPR ID: DP17472
Authors: Ozge Akinci; Ebnem Kalemlizcan; Albert Queralto
Abstract: Foreign investors' changing appetite for risk-taking have been shown to be a key determinant of the global financial cycle. Such fluctuations in risk sentiment also correlate with the dynamics of UIP premia, capital flows, and exchange rates. To understand how these risk sentiment changes transmit across borders, we propose a two-country macroeconomic framework. Our model features cross-border holdings of risky assets by U.S. financial intermediaries who operate under financial frictions, and who act as global intermediaries in that they take on foreignasset risk. In this setup, an exogenous increase in U.S.-specific uncertainty, modeled as higher volatility in U.S. assets, leads to higher risk premia in both countries. This occurs because higher uncertainty leads to deleveraging pressure on U.S. intermediaries, triggering higher global risk premia and lower global asset values. Moreover, when U.S. uncertainty rises, the exchange rate in the foreign country vis-`a-vis the dollar depreciates, capital flows out of the foreign country, and the UIP premium increases in the foreign country and decreases in the U.S., as in the data.
Keywords: financial frictions; risk premia; time-varying uncertainty; intermediary asset pricing; financial spillovers; global financial cycle
JEL Codes: E32; E44; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| US-specific uncertainty (D89) | higher risk premia in both countries (G15) |
| higher risk premia in both countries (G15) | lower global asset values (F65) |
| US-specific uncertainty (D89) | depreciation of foreign exchange rate against the dollar (F31) |
| depreciation of foreign exchange rate against the dollar (F31) | capital outflows from the foreign country (F21) |
| US-specific uncertainty (D89) | changes in UIP premiums in the foreign country (F29) |
| US-specific uncertainty (D89) | changes in UIP premiums in the US (G52) |
| US-specific uncertainty (D89) | spillover effects to emerging markets (F69) |
| spillover effects to emerging markets (F69) | co-movements in risky asset prices and capital flows (F32) |