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Uncovering the portfolio balance channel with the use of sovereign credit ratings

Author

Listed:
  • Laura Andrade-Pardo

    (Pontificia Universidad Javeriana, Colombia)

  • Oscar Valencia-Arana

    (Banco de la República Colombia, Colombia)

  • Diego Vásquez-Escobar

    (Banco de la República Colombia, Colombia)

  • Mauricio Villamizar-Villegas

    (Banco de la República Colombia, Colombia)

Abstract

In this paper we study exchange rate effects due to shifts in the portfolio composition of the Colombian financial sector during 2003–2014. We first provide a theoretical understanding of the channel's transmission mechanism by modeling how the banking sector optimally allocates its portfolio composition. This allows us to characterize departures from the uncovered interest rate parity condition (UIP) in terms of foreign and domestic assets. In the empirical application, we control for a potential simultaneity bias by using a novel instrument for portfolio compositions: the use of sovereign credit ratings and outlook changes made by Moody's, Standard and Poor's and Fitch Ratings. Our findings indicate that shifts in portfolio balances affect only the long term (5-year) risk premium in up to five months before the effects subside. Additionally, we find stronger and more persistent portfolio effects in cases in which US ratings increased relative to Colombian ratings.

Suggested Citation

  • Laura Andrade-Pardo & Oscar Valencia-Arana & Diego Vásquez-Escobar & Mauricio Villamizar-Villegas, 2016. "Uncovering the portfolio balance channel with the use of sovereign credit ratings," Revista ESPE - Ensayos sobre Política Económica, Banco de la Republica de Colombia, vol. 34(81), pages 191-205, December.
    • Handle: RePEc:bdr:ensayo:v:34:y:2016:i:81:p:191-205
    DOI: 10.1016/j.espe.2016.08.003
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    More about this item

    Keywords

    Portfolio balance channel; Sovereign credit rating; Uncovered interest rate parity; Monetary trilemma;
    All these keywords.

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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