- Sovereign Default Risk and Foreign Currency Returns [ Latest version ]
Many currencies exhibit non-zero average returns with respect to US dollar, in an apparent violation of textbook uncovered and covered interest parities. I first show that in the cross-section of countries foreign currency returns are positively related to the sovereign default risk, and then reconcile this finding with the standard theory via the “peso problem”. Market players collect premium for bearing the risk of sharp devaluation in case of default. Since defaults are rare in the data, default premium manifests itself in higher currency returns. To formalize the link between default risk and currency returns, I discipline quantitatively a model “with default” based on Arellano (2008) for a set of developing countries. I then use the implications of this model to construct an econometric model for cross-section of currency returns that I estimate using extended Fama and MacBeth (1973) method. I find strong evidence supporting the “peso problem” explanation: credit default swaps’ spreads serving as proxy for the risk of default explain around 25% of the cross-country variation of average currency returns.
- Non-linear Dynamic Factor Models for Financial and Macroeconomic Applications (with P. Guerron-Quintana and M. Zhong) [ Fed Working Paper 2023 version ] [ 5 min presentation by Molin ]
Through the lens of a nonlinear dynamic factor model, we study the role of exogenous
shocks and internal propagation forces in driving the fluctuations of macroeconomic
and financial data. The proposed model 1) allows for nonlinear dynamics in the
state and measurement equations; 2) can generate asymmetric, state-dependent, and
size-dependent responses of observables to shocks; and 3) can produce time-varying
volatility and asymmetric tail risks in predictive distributions. We find evidence in
favor of nonlinear dynamics in two important U.S. applications. The first uses interest
rate data to extract a factor allowing for an effective lower bound and nonlinear dynamics.
Our estimated factor coheres well with the historical narrative of monetary
policy. We find that allowing for an effective lower bound constraint is crucial. The
second recovers a credit cycle. The nonlinear component of the factor boosts credit
growth in boom times while hinders its recovery post-crisis. Shocks in a credit crunch
period are more amplified and persist for longer compared with shocks during a credit
boom.
- Healthcare and the Macroeconomy (with T. Drautzburg and P. Guerron-Quintana)
An important question in economics is why health varies over the business cycle. Is it the result of wealth or substitution effect following standard business cycle? Or is it because shock in the health segment of the economy? This paper tries to answer this question from an empirical perspective using micro data, and a structural heterogeneous agent model that features endogenous health risks and health expenditures and time spent on health care.
- Why Not Borrow, Invest, and Escape Poverty? (with D. Celik, O. Moav, Z. Neeman, and H. Zoabi) [ Updated April 2023 version (ArXiV) ]
Take up of microcredit by the poor for investment in businesses or human capital
turned out to be very low. We show that this could be explained by risk aversion,
without relying on fixed costs or other forms of non-convexity in the technology, if the
investment is aimed at increasing the probability of success. Under this framework,
rational risk-averse agents choose corner solutions, unlike in the case of a risky investment
with an exogenous probability of success. Our online experiment confirms our
theoretical predictions about how agents’ choices differ when facing the two types of
investments.
- Non-linear VARs (with T. Drautzburg, P. Guerron-Quintana, and M. Zhong)
