Which exchange rate matters to global investors?

How do exchange rates affect global bond portfolios? Using security-level holdings data, we find that euro area investors systematically shed emerging-market and small open-economy sovereign bonds as the US dollar strengthens, confirming the dollar’s role as a global risk factor even for euro-based investors. More distinctively, as the euro strengthens, investors shed bonds denominated in an issuer’s local currency while maintaining exposure to the same issuer’s foreign currency bonds. This behavior is consistent with currency mismatches on investors’ balance sheets. We explain these findings with a Value-at-Risk portfolio choice model that brings out separate roles for local, foreign and reference currencies.