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On The Spillover Of Exchangerate Risk Into Default Risk

Author

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  • Miloš Božović
  • Branko Urošević
  • Boško Živković

Abstract

In order to reduce the exchange-rate risk, banks in emerging markets are typically denominating their loans in foreign currencies. However, in the event of a substantial depreciation of the local currency, the payment ability of a foreign-currency borrower may be reduced significantly, exposing the lender to additional default risk. This paper analyses how the exchange-rate risk of foreigncurrency loans spills over into default risk. We show that in an economy where foreigncurrency loans are a dominant source of financing economic activity, depreciation of the local currency establishes a negative feedback mechanism that leads to higher default probabilities, reduced credit supply, and reduced growth. This finding has some important implications that may be of special interest for regulators and market participants in emerging economies.

Suggested Citation

  • Miloš Božović & Branko Urošević & Boško Živković, 2009. "On The Spillover Of Exchangerate Risk Into Default Risk," Economic Annals, Faculty of Economics, University of Belgrade, vol. 54(183), pages 32-55, October -.
  • Handle: RePEc:beo:journl:v:54:y:2009:i:183:p:32-55
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    File URL: http://ea.ekof.bg.ac.rs/pdf/183/1_02.pdf
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    References listed on IDEAS

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    1. Jarrow, Robert A. & Turnbull, Stuart M., 2000. "The intersection of market and credit risk," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 271-299, January.
    2. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    3. Dan Galai & Zvi Wiener, 2012. "Credit Risk Spreads in Local and Foreign Currencies," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44(5), pages 883-901, August.
    4. Breuer, Thomas & Jandacka, Martin & Rheinberger, Klaus & Summer, Martin, 2008. "Regulatory capital for market and credit risk interaction: is current regulation always conservative?," Discussion Paper Series 2: Banking and Financial Studies 2008,14, Deutsche Bundesbank.
    5. Diaz Weigel, Diana & Gemmill, Gordon, 2006. "What drives credit risk in emerging markets? The roles of country fundamentals and market co-movements," Journal of International Money and Finance, Elsevier, vol. 25(3), pages 476-502, April.
    6. Darrell Duffie & Lasse Heje Pedersen & Kenneth J. Singleton, 2003. "Modeling Sovereign Yield Spreads: A Case Study of Russian Debt," Journal of Finance, American Finance Association, vol. 58(1), pages 119-159, February.
    7. Jose Giancarlo Gasha & Andre O Santos & Jorge A Chan-Lau & Carlos I. Medeiros & Marcos R Souto & Christian Capuano, 2009. "Recent Advances in Credit Risk Modeling," IMF Working Papers 09/162, International Monetary Fund.
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    Cited by:

    1. Dejan Šoškić, 2015. "Inflation Targeting Challenges In Emerging Market Countries: The Case Of Serbia," Economic Annals, Faculty of Economics, University of Belgrade, vol. 60(204), pages 7-30, January –.
    2. repec:beo:journl:v:62:y:2017:i:212:p:155-188 is not listed on IDEAS
    3. Petar Marković & Branko Urošević, 2011. "Market Risk Stress Testing For Internationally Active Financial Institutions," Economic Annals, Faculty of Economics, University of Belgrade, vol. 56(188), pages 62-90, January –.

    More about this item

    Keywords

    foreign currency loans; exchange-rate risk; default risk; banking regulation; integrated risk analysis;

    JEL classification:

    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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