Why are Countries’ Asset Portfolios Exposed to Nominal Exchange Rates?
IMF Working Papers, December 22, 2017
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- Why are Countries’ Asset Portfolios Exposed to Nominal Exchange Rates?
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Bibliographic details
- Authors: Jonathan J. Adams, Philip Barrett
- Published: December 22, 2017
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781484335468.001
Summary
- Most countries hold large gross asset positions, lending in domestic currency and borrowing in foreign. Thus, their balance sheets are exposed to nominal exchange rates.
- When asset markets are incomplete, nominal exchange rate exposure allows countries to partially insure against shocks that move real exchange rates.
- Asset market incompleteness can simultaneously generate realistic gross asset positions and resolve the Backus-Smith puzzle: that relative consumptions and real exchange rates correlate negatively.
- Local perturbation methods that use stabilizing endogenous discount factors are inaccurate when average and steady state interest rates differ.
- A novel global solution method is developed to accurately solve the model.
Key findings
- Incomplete asset markets provide a rationale for why countries hold asset portfolios exposed to nominal exchange rates.
- Nominal exchange rate exposure functions as partial insurance against shocks to real exchange rates under market incompleteness.
- The model with asset market incompleteness can reproduce:
- realistic gross asset positions, and
- the negative correlation between relative consumptions and real exchange rates (the Backus-Smith puzzle).
- Standard local perturbation solution methods can be misleading when average and steady state interest rates differ; a global solution method is required for accuracy.
Methodology and model features
- The analysis relies on a general equilibrium model with incomplete asset markets.
- The role of nominal exchange rate exposure is evaluated as an insurance mechanism against real-exchange-rate-moving shocks.
- Attention is paid to solution method accuracy:
- Local perturbation methods that employ stabilizing endogenous discount factors are shown to be inaccurate under certain interest rate conditions.
- A novel global solution method is introduced to address these inaccuracies and to accurately solve the model.
Policy and analytical implications
- Empirical patterns of countries’ gross asset positions and currency denomination choices can be rationalized by asset market incompleteness and the insurance role of nominal exchange rate exposure.
- Researchers and policymakers should be cautious using local perturbation methods when average and steady state interest rates differ; global solution methods may be necessary for reliable quantitative assessments.
- Understanding currency composition of countries’ external assets and liabilities requires accounting for market incompleteness and the associated insurance motivations.
Authors: Jonathan J. Adams, Philip Barrett. Publication date: December 22, 2017. IMF Working Papers.
Content in this bundle
- Why are Countries’ Asset Portfolios Exposed to Nominal Exchange Rates?, WP/17/291, December 2017