Topic: Intermediary Leverage and Currency Risk Premium
Speaker: Xiang Fang, University of Hong Kong
Time: Friday, 20 September, 12:15-13:30
Location: Room K01, Guanghua Building 2
This paper proposes an intermediary-based explanation of the risk premium of currency carry trade in a model with a cross-section of small open economies. In the model, bankers in each country lever up and hold interest-free cash as liquidity buffers against funding shocks. Countries set different nominal interest rates, while low interest rates encourage bankers to take high leverage. Consequently, bankers' wealth drops sharply with a negative shock. This reduces foreign asset demand and leads to a domestic appreciation, which in turn makes low-interest-rate currencies good hedges. The model implies covered interest rate parity deviations when safe assets differ in liquidity. The empirical evidence is consistent with the main model implications: (i) Low-interestrate countries have high bank leverage and low currency returns; (ii) the carry trade return is procyclical with a positive exposure to the bank stock return; and (iii) the carry trade CAPM beta increases with the stock market volatility.
Dr. Xiang Fang is an assistant Professor in the University of Hong Kong, Faculty of Business and Economics. He received his Ph.D. degree in economics from the University of Pennsylvania in 2019. He is interested in broad topics in international finance, asset pricing, and their connections to the macro economy, especially the crucial role of financial intermediaries.
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