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The role of bond markets when portfolio choice is constrained

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In a dynamic equilibrium setting with multiple assets, we show 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 upward 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 the expected rate of appreciation falls.

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en

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application/pdf

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http://flora.insead.edu/fichiersti_wp/inseadwp2011/2011-26.pdf

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Copyright INSEAD. All rights reserved