Dominant Currency Pricing and Currency Risk Premia

This paper argues that currency risk premia are an endogenous outcome of a country’s fundamental trade and financial structures. Empirically, we isolate global risk factors from currency returns and show that a country’s exposure to these factors is jointly determined by its share of dollar invoicing and its net foreign debt position. We then develop a small open-economy model with dominant-currency pricing (DCP) and dollar-denominated liabilites to explain the underlying mechanism. The model demonstrates that empirically plausible risk premia require the interaction of both frictions. High dollar invoicing mutes the expenditure switching channel, while high dollar debt creates a potent, contractionary financial channel. Together, these frictions make currency depreciations recessionary (countercyclical), rendering the currency a poor hedge and "risky" for investors. We show this has a first-order policy consequence: the resulting risk premium raises the economy’s neutral interest rate, leading to structurally high inflation under a standard Taylor rule. Our results show how trade and financial frictions jointly create currency risk and pose a fundamental challenge for monetary policy