Albert Queralto - Uncertainty Shocks, Global Banks, and Foreign Currency Arbitrage

Research Seminar - Albert Queralto - Uncertainty Shocks, Global Banks, and Foreign Currency Arbitrage

Co-Authors: Ozge Akinci (Federal Reserve Bank of New York) and Sebnem Kalemli-Ozcan (University of Maryland) 

Abstract:

U.S. investors’ changing appetite for risk-taking has been shown to be a key determinant of the global financial cycle -- co-movement of risky asset prices, capital flows and bank leverage. Such fluctuations in risk sentiment also correlate with the dynamics of UIP premia and exchange rates. We propose an open-economy macroeconomic framework with global banks to investigate how uncertainty shocks transmit across borders. 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. financial assets, leads to higher risk premia in both countries. The channel is that higher uncertainty leads to deleveraging pressure on global financial intermediaries, triggering higher asset and currency risk premia and lower asset values. Higher returns to risky asset hold both in the U.S. and in the other country, whereas the currency risk only rises in the foreign country as the exchange rate in the foreign country depreciates vis-a-vis the USD, whereas safe rate in the U.S. go down given higher uncertainty. Our model's predictions are consistent with the data.

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