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Exchange Rates

Paper Session

Sunday, Jan. 6, 2019 10:15 AM - 12:15 PM

Hilton Atlanta, Grand Ballroom B
Hosted By: American Finance Association
  • Chair: Laura Veldkamp, Columbia University

The Two-Pillar Policy for the RMB

Urban Jermann
,
University of Pennsylvania
Bin Wei
,
Federal Reserve Bank of Atlanta
Vivian Yue
,
Emory University

Abstract

In this paper we document stylized empirical facts about recent exchange rate
(RMB) policies in China. The formation mechanism of the central parity is based
on the "two-pillar approach" that balances RMB index "stability" and exchange rate
"flexibility." We then develop a tractable no-arbitrage model of the RMB under the
"two-pillar approach." Using the model we estimate the fundamental exchange rate,
the probability of continuation of the two-pillar approach in the future, and the weights
put on both pillars. Our model is able to predict both the end of the two-pillar policy
in May 2017 when an additional unspecified "countercyclical factor" was introduced
for the first time, and the return to the two-pillar policy in January 2018 when the
countercylical factor was suspended. The estimated model not only fits the spot rate
and option prices well in the sample, but also forecast future central parity and spot
rates out of the sample.

Exchange Rate Reconnect: Capital Flows and Currency Dynamics

Andrew Lilley
,
Harvard University
Matteo Maggiori
,
Harvard University
Brent Neiman
,
University of Chicago
Jesse Schreger
,
Columbia University

Abstract

We establish that global portfolios are driven by an often neglected aspect: the currency of denomination of assets. Using a dataset of $27 trillion in security-level investment positions, we demonstrate that investor holdings are biased toward their own currencies to such an extent that each country holds the bulk of all debt securities denominated in their own currency, even those issued by foreign borrowers in developed countries. Surprisingly, currency is such a strong predictor of the nationality of a security's holder that the nationality of the issuer-to date, the powerful predictor in a voluminous literature on cross-border portfolios-adds very little explanatory power. While large firms issue bonds in foreign currency and borrow from foreign capital. These patterns hold broadly across countries with the exception of countries, like the United States, that issue an international currency.

Dollar Safety and the Global Financial Cycle

Arvind Krishnamurthy
,
Stanford University
Zhengyang Jiang
,
Northwestern University
Hanno Lustig
,
Stanford University

Abstract

US monetary policy has an outsized impact on the world economy, a phenomenon that Rey (2013) dubs the “global financial cycle.” Changes in the US dollar also have an outsized impact on the world economy and shocks to the US dollar carry high risk prices in the cross-section of currencies. We build a model to rationalize these facts stemming from the special demand for dollar safe assets. In the model, dollar safe assets trade at a premium; that is, they offer especially low returns. Banks and firms that have the collateral to issue dollar safe assets can collect this premium. Institutions in the U.S. do so against dollar collateral, while institutions in foreign countries do so against local currency collateral, but in the process take on exchange rate risk. Changes in U.S. monetary policy impact the supply of dollar safe assets, but under plausible policy rules, do not offset shocks to safe asset demand. Shocks to U.S. monetary policy and shocks to the value of the dollar transmit across the globe and are a global risk factor. We present evidence from movements in the Treasury basis that support the mechanism underlying our theory.
Discussant(s)
Wenxin Du
,
Federal Reserve Board
Riccardo Colacito
,
University of North Carolina-Chapel Hill
Jesse Schreger
,
Columbia University
JEL Classifications
  • G1 - General Financial Markets