Risk capacity, portfolio choice and exchange rates

Summary

Focus

Fluctuations in the risk sentiment of global portfolio investors can lead to shifts in portfolio holdings, even without changes in fundamentals or currency mismatches on the part of the borrower. Such shifts in risk sentiment can occur when the investor's risk constraint is relaxed or tightened in reaction to market events. The focus is on how exchange rate changes affect risk constraints and hence the investor portfolios of sovereign bonds issued in the local currencies of emerging market economies (EMEs).

Contribution

We develop a theory of a global investor who holds a diversified portfolio of EME bonds in different currencies, but who evaluates gains and losses in dollar terms and is subject to a risk constraint. Any broad-based EME currency appreciation increases the investor's risk capacity by relaxing the risk constraint and increasing the investor's economic capital. We empirically assess the link between risk capacity, portfolio choice and exchange rates based on a panel of EMEs using fund-level bond purchases, bond spreads and high-frequency exchange rate shocks. 

Findings

The key prediction of the theory is that a broad-based weakening of the dollar leads to larger portfolio inflows (and a larger compression in spreads) in the local currency bond market of a particular EME than an equivalent percentage depreciation of the dollar against the EME's currency. Empirical evidence strongly supports the key predictions of our theory.

Abstract

We lay out a model of risk capacity for global portfolio investors in which swings in exchange rates can affect their risk-taking capacity in a Value-at-Risk framework. Exchange rate fluctuations induce shifts in portfolio holdings of global investors, even in the absence of currency mismatches on the part of the borrowers. A currency appreciation for an emerging market borrower that is part of a broad-based appreciation of emerging market currencies leads to larger bond portfolio inflows than the equivalent appreciation in the absence of a broad-based appreciation. As such, the broad dollar index emerges as a global factor in bond portfolio flows. The empirical evidence strongly supports the predictions of the model.

JEL classification: G12, G15, G23. 

Keywords: bond spread, capital flow, credit risk, emerging market, exchange rate.