Wednesday, February 16, 2011

The Role of Bond Markets when Portfolio Choice is Constrained
INSEAD Working Paper 2011/26/FIN

In a dynamic equilibrium setting with multiple assets, this paper shows that restricting investors’ leverage can lead to rising interest rates. When investment opportunities are good and investors have access to international bond markets, a constraint will cause them to shift their loans more heavily into one country, putting upwards pressure on interest rates. They choose to sacrifice diversification to gain more risk exposure, taking advantage of foreign bond markets’ exposure to currency risk. The resulting pressure on interest rate differentials is also reflected in exchange rates. Even in the benchmark unconstrained economy, carry trades are profitable due to a currency risk premium. But the distortion that a constraint imposes on investors’ portfolios induces a negative skew in exchange rates: as countries’ economic risks are more unevenly shared among investors, exchange rate volatility rises while its expected rate of appreciation falls.