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U.S. Dollar Risk Premiums and Capital Flows

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  • Ravi Balakrishnan
  • Volodymyr Tulin
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    Abstract

    This paper sheds light on the attractiveness of U.S. assets by studying dollar risk premiums, calculated using Consensus exchange rate forecasts, and linking them to bilateral capital flows. The paper finds that the presence of negative dollar risk premiums (i.e. expectations of a dollar depreciation net of interest rate effects) amid record capital inflows could suggest that investors may favor U.S. assets for structural reasons. One possible explanation could be that the Asian crisis created a large pool of savings searching for relatively riskless investment opportunities, which were provided by deep, liquid, and innovative U.S. financial markets with robust investor protection. Moreover, the continued attractiveness of U.S. financial markets to European investors suggests that they offer a large array of assets, with different risk/return characteristics, that facilitate the structuring of diversified investment portfolios. Looking forward, this suggests that the allocative efficiency of U.S. financial markets could mitigate risks of a disorderly unwinding of global current account imbalances.

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    Bibliographic Info

    Paper provided by International Monetary Fund in its series IMF Working Papers with number 06/160.

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    Length: 27
    Date of creation: 01 Jun 2006
    Date of revision:
    Handle: RePEc:imf:imfwpa:06/160

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    Keywords: Capital flows; Interest rates; Exchange rates; risk premium; bonds; investors; treasury bonds; financial markets; bond; stock market; corporate bonds; foreign investors; bond flows; interest differentials; international finance; nominal interest rate; corporate bond; investor protection; financial system; expected returns; rate of return; rates of return; financial institutions; net foreign assets; deposit rates; international capital; government bond; real interest rates; hedge; risk preference; external financing; financial assets; foreign currency; local stock market; financial globalization; foreign investment; net bond; bond categories; overvaluation; local bond; foreign bond; hedging; financial stability; treasury bond; bond rates; export flows; stochastic discount; bond flow; stochastic discount factor; junk bonds; international investors;

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    References

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    1. Ricardo J. Caballero & Emmanuel Farhi & Pierre-Olivier Gourinchas, 2008. "An Equilibrium Model of "Global Imbalances" and Low Interest Rates," American Economic Review, American Economic Association, vol. 98(1), pages 358-93, March.
    2. Campbell, John Y, 1993. "Intertemporal Asset Pricing without Consumption Data," American Economic Review, American Economic Association, vol. 83(3), pages 487-512, June.
    3. Maurice Obstfeld & Kenneth S. Rogoff, 2005. "Global Current Account Imbalances and Exchange Rate Adjustments," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 36(1), pages 67-146.
    4. Chinn, Menzie & Frankel, Jeffrey, 1994. "Patterns in Exchange Rate Forecasts for Twenty-five Currencies," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 26(4), pages 759-70, November.
    5. Martin Lettau & Sydney Ludvigson, 1999. "Resurrecting the (C)CAPM: a cross-sectional test when risk premia are time-varying," Staff Reports 93, Federal Reserve Bank of New York.
    6. Ayuso, Juan & Restoy, Fernando, 1996. "Interest rate parity and foreign exchange risk premia in the ERM," Journal of International Money and Finance, Elsevier, vol. 15(3), pages 369-382, June.
    7. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
    8. Joseph W. Gruber & Steven B. Kamin, 2005. "Explaining the global pattern of current account imbalances," International Finance Discussion Papers 846, Board of Governors of the Federal Reserve System (U.S.).
    9. Charles P. Thomas & Francis E. Warnock & Jon Wongswan, 2006. "The Performance of International Equity Portfolios," NBER Working Papers 12346, National Bureau of Economic Research, Inc.
    10. Groen, Jan J.J. & Balakrishnan, Ravi, 2006. "Asset price based estimates of sterling exchange rate risk premia," Journal of International Money and Finance, Elsevier, vol. 25(1), pages 71-92, February.
    11. Olivier Blanchard & Francesco Giavazzi & Filipa Sa, 2005. "The U.S. Current Account and the Dollar," NBER Working Papers 11137, National Bureau of Economic Research, Inc.
    12. Robin Brooks & Hali Edison & Manmohan S. Kumar & Torsten Sløk, 2004. "Exchange Rates and Capital Flows," European Financial Management, European Financial Management Association, vol. 10(3), pages 511-533.
    13. Charles P. Thomas, 2006. "The Performance of International Equity Portfolios," The Institute for International Integration Studies Discussion Paper Series iiisdp162, IIIS.
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    Cited by:
    1. Stephen Gilmore & Fumio Hayashi, 2008. "Emerging Market Currency Excess Returns," NBER Working Papers 14528, National Bureau of Economic Research, Inc.
    2. Guy Meredith, 2007. "Debt Dynamics and Global Imbalances," IMF Working Papers 07/4, International Monetary Fund.
    3. Ravi Balakrishnan & Volodymyr Tulin & Tamim Bayoumi, 2007. "Globalization, Gluts, innovation or Irrationality," IMF Working Papers 07/160, International Monetary Fund.
    4. Joseph W. Gruber & Steven B. Kamin, 2008. "Do differences in financial development explain the global pattern of current account imbalances?," International Finance Discussion Papers 923, Board of Governors of the Federal Reserve System (U.S.).

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