Which exchange rate matters to global investors?
(September 2024, revised October 2025)
Summary
Focus
How do exchange rates affect the portfolio decisions of global investors? We examine detailed statistics to measure how bond investors respond to changes in the US dollar, the euro and the currencies of emerging markets and advanced economies. Our findings show that euro-based investors respond differently to various exchange rates and currency mismatches. To explain these findings better, we build a portfolio choice model that considers the different roles of local, foreign and reference currencies.
Contribution
We shed new light on the financial channel of exchange rates. The risks of currency mismatches have been evident in many financial crises where depreciations expose borrowers to higher debt burdens. Currency mismatches on the lender side, however, remain less explored. We go beyond the few existing studies on US dollar-based investors. By focusing on euro-based investors, we can identify their currency mismatches separately from the dollar's role as a global risk factor.
Findings
Our findings show that euro-based investors react differently to three types of exchange rates. When the dollar strengthens, investors sell bonds across the board, as this signals tighter global financial conditions. When the euro strengthens, investors sell local currency bonds because these bonds lose value in terms of euros. And the more a currency depreciates against the euro, the more local currency bonds will be sold. The reason for this is the currency mismatch lenders face on their own balance sheets. These findings help explain why emerging market economies continue to face volatile capital flows even if they borrow in their own currency.
Abstract
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.
JEL Classification: F31, G11, G15, G23
Keywords: Currency mismatch, balance sheet effects, emerging markets, exchange rates, institutional investors, sovereign bonds
