Working Paper: NBER ID: w30026
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 foreign asset 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-à -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: uncertainty shocks; capital flows; international risk spillovers
JEL Codes: F3; F31; F32; F4; F41; F44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| US-specific uncertainty (D89) | risk premia (G22) |
| US-specific uncertainty (D89) | asset values (G32) |
| US-specific uncertainty (D89) | capital outflows (F32) |
| US-specific uncertainty (D89) | exchange rate depreciation (F31) |
| US uncertainty (D89) | risk premia (G22) |
| US uncertainty (D89) | capital flows (F32) |
| US uncertainty (D89) | global financial cycle (F65) |