nep-ifn New Economics Papers
on International Finance
Issue of 2019‒09‒23
four papers chosen by
Vimal Balasubramaniam
University of Oxford

  1. Estimation of Large Dimensional Conditional Factor Models in Finance By Patrick Gagliardini; Elisa Ossola; O. Scaillet
  2. Exchange Rate and Interest Rate Disconnect: The Role of Capital Flows, Currency Risk and Default Risk By Sebnem Kalemli-Ozcan; Liliana Varela
  3. Mussa Puzzle Redux By Oleg Itskhoki; Dmitry Mukhin
  4. Global Banks and Systemic Debt Crises By Juan Morelli; Diego Perez; Pablo Ottonello

  1. By: Patrick Gagliardini (USI Università della Svizzera italiana; Swiss Finance Institute); Elisa Ossola (European Commission, Joint Research Centre); O. Scaillet (University of Geneva GSEM and GFRI; Swiss Finance Institute; University of Geneva - Research Center for Statistics)
    Abstract: This chapter provides an econometric methodology for inference in large-dimensional conditional factor models in finance. Changes in the business cycle and asset characteristics induce time variation in factor loadings and risk premia to be accounted for. The growing trend in the use of disaggregated data for individual securities motivates our focus on methodologies for a large number of assets. The beginning of the chapter outlines the concept of approximate factor structure in the presence of conditional information, and develops an arbitrage pricing theory for large-dimensional factor models in this framework. Then we distinguish between two different cases for inference depending on whether factors are observable or not. We focus on diagnosing model specification, estimating conditional risk premia, and testing asset pricing restrictions under increasing cross-sectional and time series dimensions. At the end of the chapter, we review some of the empirical findings and contrast analysis based on individual stocks and standard sets of portfolios. We also discuss the impact on computing time-varying cost of equity for a firm, and summarize differences between results for developed and emerging markets in an international setting.
    Keywords: large panel, factor model, conditional information, risk premium, asset pricing, emerging markets
    JEL: C12 C13 C23 C51 C52 G12
    Date: 2019–08
  2. By: Sebnem Kalemli-Ozcan (University of Maryland); Liliana Varela (London School of Economics)
    Abstract: Using survey based measures of exchange rate expectations from a large set of advanced countries and emerging markets during 1996–2015, we document new facts on international arbitrage and exchange rate determination. We find that positive interest rate differentials imply expected depreciation as predicted by the no-arbitrage condition, however the expected depreciation is not enough to offset the interest rate differentials, leading to UIP deviations. To understand why there is not a full offset, we evaluate the response of each component of the UIP relation—that is the interest rate differential term and and exchange rate adjustment term—to changes in global risk and country fundamentals. This exercise reveals that, in short horizons (1-3 month), expected depreciation as a response to a given shock is large enough to offset most of the interest rate differentials, narrowing down the UIP deviations in general, and vanishing them in the advanced economies. In long horizons (12 month), this is not the case due to a combination of different factors in different countries. In advance countries, currency risk plays a key role, where in bad times (high global risk), currency depreciates more than the expectations, leading to larger deviations. In emerging markets, there is not enough movement in the exchange rate adjustment term. Capital outflows from emerging markets as a result of both higher global risk and worsening country fundamentals lead to larger interest rate differentials. Although there is an expected and actual depreciation as a result of such outflows, these are not enough to offset the interest rate differentials as the role played by the default risk is more important.
    Date: 2019
  3. By: Oleg Itskhoki (Princeton University); Dmitry Mukhin (Yale University)
    Abstract: The Mussa (1986) puzzle - a sharp and simultaneous increase in the volatility of both nominal and real exchange rates after the end of the Bretton Woods System of pegged exchange rates in early 1970s - is commonly viewed as a central piece of evidence in favor of monetary non-neutrality. Indeed, a change in the monetary regime has caused a dramatic change in the equilibrium behavior of a real variable - the real exchange rate. The Mussa fact is further interpreted as direct evidence in favor of models with nominal rigidities in price setting (sticky prices). We show that this last conclusion is not supported by the data, as there was no simultaneous change in the properties of the other macro variables - neither nominal like inflation, nor real like consumption, output or net exports. We show that the extended set of Mussa facts equally falsifies both flexible-price RBC models and sticky-price New Keynesian models. We present a resolution to this broader puzzle based on a model of segmented financial market - a particular type of financial friction by which the bulk of the nominal exchange rate risk is held by a small group of financial intermediaries and not shared smoothly throughout the economy. We argue that rather than discriminating between models with sticky versus flexible prices, and monetary versus productivity shocks, the Mussa puzzle provides sharp evidence in favor of models with monetary non-neutrality arising due to financial market segmentation. Sticky prices are neither necessary, nor sufficient for the qualitative success of the model.
    Date: 2019
  4. By: Juan Morelli (NYU Stern); Diego Perez (New York University); Pablo Ottonello (University of Michigan)
    Abstract: We study the role of financial intermediaries in the global market for risky external debt. We first provide empirical evidence measuring the effect of global banks’ net worth on bond prices of emerging-market economies. We exploit within-borrower bond variation and show that, around the collapse of Lehman Brothers, bonds held by more distressed global banks experienced larger price contractions. We then construct a model of global banks’ lending to emerging economies and quantify their role using our empirical estimates and other key data. In the model, banks’ net worths affect bond prices by the combination of a form of market segmentation and banks’ financial frictions. We show that these banks’ exposure to emerging economies is the key to determine their role in propagating shocks. With the current observed exposure, global banks play an important role in transmitting shocks originating in developed economies, accounting for the bulk of the variation of spreads in emerging economies during the recent global financial crisis. Global banks help explain key patterns of debt prices observed in the data, and the evolution of their exposure over the last decades can explain the changing nature of systemic debt crises in emerging economies.
    Date: 2019

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