Risk capacity, portfolio choice and exchange rates

(July 2022, revised January 2025)

Summary

Focus

Fluctuations in the risk sentiment of global portfolio investors can lead to shifts in portfolio holdings, even without changes in fundamentals or currency mismatches on the part of the borrower. Such shifts in risk sentiment can occur when the investor's risk constraint is relaxed or tightened in reaction to market events. The focus is on how exchange rate changes affect risk constraints and hence the investor portfolios of sovereign bonds issued in the local currencies of emerging market economies (EMEs).

Contribution

We develop a theory of a global investor who holds a diversified portfolio of EME bonds in different currencies, but who evaluates gains and losses in dollar terms and is subject to a risk constraint. Any broad-based EME currency appreciation increases the investor's risk capacity by relaxing the risk constraint and increasing the investor's economic capital. We empirically assess the link between risk capacity, portfolio choice and exchange rates based on a panel of EMEs using fund-level bond purchases, security-level bond spreads and high-frequency exchange rate shocks. 

Findings

The key prediction of the theory is that a broad-based weakening of the dollar leads to larger portfolio inflows (and a larger compression in spreads) in the local currency bond market of a particular EME than an equivalent percentage depreciation of the dollar against the EME's currency. Empirical evidence strongly supports the key predictions of our theory.

Abstract

We assess how swings in exchange rates affect global bond investors' portfolio allocations to emerging market economy (EME) local currency bonds based on a portfolio choice model and empirical analyses using granular security-level bond spread data and fund-level bond flow data. We lay out a portfolio choice model in which swings in exchange rates can affect investors' risk-taking capacity in a Value-at-Risk framework. Exchange rate fluctuations induce shifts in portfolio holdings of global investors even in the absence of currency mismatches on the part of the borrowers and in particular when they are broadly common across EMEs rather than idiosyncratic. Empirical evidence from granular security-level bond spread and fund-level bond flow data supports the predictions of the model. An appreciation of an EME currency against the US dollar increases bond fund inflows and reduces bond spreads. The effect is considerably stronger when the appreciation is broad-based, as captured by the broad US dollar index, than when it is idiosyncratic.

JEL classification: G12, G15, G23

Keywords: bond spread, capital flow, credit risk, emerging market, exchange rate