- Sovereign Default Risk and Foreign Currency Returns (Job market paper) [ 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) [Most recent version] [ 5 min presentation by Molin ]
Macroeconomic and financial data tend to display large and sudden swings, particularly so during periods of turmoil. To understand the role of shocks and internal forces in driving those swings, we propose a dynamic factor model that allows non-linear dynamics in the state and measurement equations. The proposed model 1) can generate asymmetric, state-dependent, and size-dependent responses of observables to shocks; 2) can produce time-varying volatility and asymmetric tail risks in predictive distributions; and 3) fits the data better than a linear factor model. Using macroeconomic and financial variables, we show how to take the model to the data. We find overwhelming evidence in favor of the nonlinear factor model over its linear counterpart in applications that include interest rates with zero lower bounds, credit default swap spreads for European countries, and nonfinancial corporate credit default swap spreads in the U.S. The results hint to an important role for a nonlinear internal propagation element to exogenous shocks.
- 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.
- The Microfinance Disappointment: an Explanation Based on Risk Aversion (with D. Celik, O. Moav, Z. Neeman, and H. Zoabi) [CEPR Discussion paper 12659 ]
Recent research indicates that microcredit has not contributed significantly to poverty reduction. Take up of affordable credit by the poor for investment in businesses, education and health, turned out to be very low. We argue that this can be explained by risk aversion, when investment affects the probability of success of a risky project. Our model abstracts from fixed costs in the production technology, commonly assumed in the existing literature. There are no imperfections in the loan market, and we abstract from assumptions about false beliefs by the poor regarding the production function or other behavioral assumptions. We design an online experiment that tests the main predictions of our mode. Finally, we conclude that to facilitate investment and thereby reduce poverty, policy should be aimed at reducing the risk faced by the poor.
- Local Governments' Policies and Business Cycle Amplification
Local government revenues and spending in the United States are procyclical. This paper introduces fiscal policy conducted by local governments to an otherwise standard New Keynesian closed economy model to assess quantitatively the contribution of spending policies into the business cycle. The procyclical nature of local government spending generates an amplification mechanism that accounts for around 10% of fluctuations in output and hours worked.
- Non-linear VARs (with T. Drautzburg, P. Guerron-Quintana, and M. Zhong)