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Foreign currency debt, risk premia and macroeconomic volatility

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  • Korinek, Anton

Abstract

This paper studies the relationships between foreign currency debt, macroeconomic volatility, and risk premia in a model of a small open emerging market economy. The external value of the local currency is counter-cyclical, so that foreign currency debt requires larger repayments than local currency debt in bad states of nature. The level of foreign currency-denominated debts, therefore, affects the volatility of aggregate demand and by extension of the exchange rate. Exchange rate volatility is in turn an important determinant of the risk premium on local currency debt. Finally, this risk premium is a major factor in the choice of local versus foreign currency for emerging market borrowers. The mutual endogeneity of foreign currency debt, risk premia, and macroeconomic volatility creates important feedback effects in the economy: small increases in international risk aversion may entail large amplification effects on macroeconomic volatility since domestic borrowers substitute towards cheaper but riskier foreign currency debt finance.

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Bibliographic Info

Article provided by Elsevier in its journal European Economic Review.

Volume (Year): 55 (2011)
Issue (Month): 3 (April)
Pages: 371-385

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Handle: RePEc:eee:eecrev:v:55:y:2011:i:3:p:371-385

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Web page: http://www.elsevier.com/locate/eer

Related research

Keywords: Foreign currency debt Volatility Risk premia Amplification;

References

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Citations

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Cited by:
  1. Anton Korinek, 2011. "Hot Money and Serial Financial Crises," IMF Economic Review, Palgrave Macmillan, vol. 59(2), pages 306-339, June.
  2. Douglas Sutherland & Peter Hoeller & Rossana Merola & Volker Ziemann, 2012. "Debt and Macroeconomic Stability," OECD Economics Department Working Papers 1003, OECD Publishing.
  3. Douglas Sutherland & Peter Hoeller, 2012. "Debt and Macroeconomic Stability: An Overview of the Literature and Some Empirics," OECD Economics Department Working Papers 1006, OECD Publishing.

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