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Sovereign Debt Portfolios, Bond Risks, and the Credibility of Monetary Policy

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  • WENXIN DU
  • CAROLIN E. PFLUEGER
  • JESSE SCHREGER

Abstract

We document that governments whose local currency debt provides them with greater hedging benefits actually borrow more in foreign currency. We introduce two features into a government's debt portfolio choice problem to explain this finding: risk‐averse lenders and lack of monetary policy commitment. A government without commitment chooses excessively countercyclical inflation ex post, which leads risk‐averse lenders to require a risk premium ex ante. This makes local currency debt too expensive from the government's perspective and thereby discourages the government from borrowing in its own currency.

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  • Wenxin Du & Carolin E. Pflueger & Jesse Schreger, 2020. "Sovereign Debt Portfolios, Bond Risks, and the Credibility of Monetary Policy," Journal of Finance, American Finance Association, vol. 75(6), pages 3097-3138, December.
  • Handle: RePEc:bla:jfinan:v:75:y:2020:i:6:p:3097-3138
    DOI: 10.1111/jofi.12965
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