Essays in Asset Pricing and International Finance

Abstract

My dissertation investigates risk dynamics and its economic driving forces in international finance settings. It consists of two chapters. In chapter one, "International Trade and the Risk in Bilateral Exchange Rates'', co-authored with Erik Loualiche, Colin Ward, and Alexander Pecora, we study the relationship between bilateral trade and exchange rate. Exchange rate volatility falls after a trade deal, driven by a decline in the systematic component of risk. The average trade deal increases trade by 50 percent over five years, reducing systematic risk by a third of a standard deviation across countries. We examine this connection in an Armington model where the structure of trade networks determines the risk in exchange rates. We estimate our model to current data and find i) that countries at the periphery of the world trade network benefit the most from lower trade barriers and ii) that a counterfactual experiment of a trade war between the US and China shows a global increase in currency risk, with effects concentrated among peripheral countries. In chapter two, "The Current Account Income Balance: External Adjustment Channel or Vulnerability Amplifier?'', co-authored with Alberto Behar, we study the income balance from counties' balance of payments accounts. The net income balance (IB) is comparable to the trade balance (TB) in size for many countries. Yet the role of the IB in mitigating external vulnerabilities or complicating external adjustment remains under-explored. This paper studies the role of the IB in stabilizing or destabilizing the current account over the cycle and in crises. We use data from IMF on the balance of payments and investment positions and utilize a factor-augmented fixed-effect counterfactual methodology, as explained in Gobillon and Magnac (2016), to estimate the causal impacts of crises on income and trade and their components. Our methodology choice was based on two main objectives. First, to control agnostically for divergent pre-trends, and second, to be robust to treatment heterogeneity. Our event study showed that the IB is lower before a crisis than in tranquil times. Moreover, in contrast to TB, the IB deteriorates during a crisis and remains worse during the crisis aftermath than in tranquil times. Therefore, crisis contingency planning exercises could be underestimating external financing gaps and thus underestimating foreign exchange reserves losses and the amount of financial support needed from the international community. The IB deterioration is more substantial (and thus financing gaps larger) for financial crises and more robust among (Advanced Economies) AEs and (Emerging Economies) EMs than among (Low-income Countries) LICs. The paper also estimates IB semi-elasticities to the exchange rate (ER). Semi-elasticities are small for most countries, so the IB is generally not a significant channel through which the ER stabilizes the current account, and trade-based semi-elasticities are, with some crucial exceptions, good proxies for current account semi-elasticities used in external sector assessments. However, the arithmetic of ER misalignment estimates means that some estimates are biased even when IB semi-elasticities are moderate. For those countries and/or those that are potentially significant contributors to global current account imbalances, the explicit inclusion of the IB channel in external sector assessments should be explored.