Government Policy Approval and Exchange Rates

(with Ivan Shaliastovich), R&R Journal of Financial Economics

Notes: US Presidential approval rate and advanced economy dollar index.

Measures of U.S. government policy approval, such as U.S. Presidential or Congressional ratings, are strongly related to persistent fluctuations in the dollar exchange rates. Contemporaneous correlations between approval ratings and the dollar value reach 50% against the advanced economy currencies, in real and nominal terms, in levels and multi-year changes. High approval ratings further forecast a decline in the dollar risk premium, a persistent increase in economic growth, and a reduction in future economic volatility several years in the future. We provide an illustrative economic model to interpret our empirical evidence. In the model, policy valuations are forward-looking and reflect net contributions of policy to economic growth. Policy valuations (approvals) increase at times of high policy-related growth and low policy-related uncertainty, which are the times of a strong dollar and low dollar risk premium. 


Presented at AFA, WFA, SFS Cavalcade, Vienna Symposium on Foreign Exchange Markets, Arizona State University*, Front Range Finance Seminar, ITAM Finance Conference*, Luxemburg School of Finance*, Midwest Macro Meeting, National University of Singapore, Singapore Management University, Univerisity of Hong Kong. 


Volatility, Intermediaries, and Exchange Rates

(with Xiang Fang), R&R Journal of Financial Economics

Notes: Circular flow in a model where the major participants in the international financial market are financial intermediaries.

We study exchange rate determination through financial intermediaries. We propose a model in which the participants in the FX market are intermediaries subject to value-at-risk
constraints. Higher volatility translates into tighter leverage constraints. Therefore, intermediaries require higher returns to hold foreign assets and the foreign currency is expected to
appreciate. Estimated by the simulated method of moments, our model quantitatively resolves the Backus-Smith puzzle, the forward premium puzzle, and the exchange rate volatility puzzle and explains deviations from covered interest rate parity. The model generates new implications for exchange rates and capital flows consistent with the data.

Presented at AEA, WFA*, EFA*, FIRS*, Econometric Society European Winter Meeting*, Econometric Society China Meeting,  Econometric Society North American Winter Meeting*, Midwest Macro Meeting*, Peking University (Guanghua), Shanghai Jiao Tong University (Antai), University of Pennsylvania*, Wharton*.


Notes: 5-year subsequent excess return, and its projection on debt-to-GDP ratio and fiscal uncertainty.

I document that higher debt-to-GDP ratio: (i) predicts higher excess stock returns with 30% five-year out-of-sample R-squared; (ii) correlates with higher credit risk premia in corporate bond excess returns and yield spreads; (iii) is associated with lower real risk-free rates and expected returns on government debt; and (iv) comoves with higher fiscal policy uncertainty. I rationalize these facts in a model featuring distortionary taxation and time-varying fiscal uncertainty. The tax risk premium is sizable and varies with fiscal uncertainty, which is endogenously linked to the debt-to-GDP ratio. Fiscal uncertainty increases debt valuation, and conversely debt raises uncertainty in fiscal consolidations.


Presented at BlackRock, CUHK, Conference on Uncertainty and Economic Activity, EFA, EconCon, Philly Fed, Goldman Sachs, Hong Kong Joint Finance Research Workshop, Midwest Macro, Mitsui Finance Symposium, University of Pennsylvania, Nanyang Technological University, SoFiE, Stockholm School of Economics, Tsinghua PBC, University of Hong Kong, University of Wisconsin-Madison, Wharton.

Notes: Relative responses of the volatility and growth rate of output (y), consumption (c), the change of net-export-to-output ratio (NX/Y), and the volatility of excess returns (rexd ) to an output volatility shock in the foreign country relative to the US. 

Volatility Risk Pass-Through ​​

(with Riccardo Colacito, Mariano M. Croce, and Ivan Shaliastovich)

We show novel empirical evidence on the significance of output volatility (vol) shocks for both currency and international quantity dynamics. Focusing on G-17 countries, we document that (1) consumption and output vols are imperfectly correlated within countries; (2) across countries, consumption vol is more correlated than output vol; (3) the pass-through of relative output vol shocks onto relative consumption vol is significant, especially for small countries; and (4) the consumption differentials vol and exchange rate vol are disconnected. We rationalize these  findings in a frictionless model with multiple goods and recursive preferences featuring a novel and rich risk sharing of vol shocks.


Presented at AEA*, WFA, Bank of Canada Central Bank Macro Modeling Workshop, Chicago Fed*, Chicago International Macro Finance Conference*, Econometric Society NASM, Econometric Society NAWM, European Summer Symposium in Financial Markets, The International Workshop at the Hanqing Advanced Institute of Economics and Finance*, The SAFE Asset Pricing Workshop*, The Second Workshop on Uncertainty (UCL)*, Stanford SITE, SED*,  SoFiE, SEA*, UBC Winter Finance Conference, Universita' della Svizzera Italiana*, Wharton*, Central Bank Research Association Annual Meeting*, Brazilian Meeting of Finance*, CEBRA Conference in Warsaw and Madrid*, Erasmus University*, Tilburg University*, Maastricht University*, Norwegian School of Economics*, Indiana University*, Federal Reserve Bank of San Francisco*, University of Virginia*.


The Risks of Safe Assets

(with Lukas Schmid and Amir Yaron)

Notes: Impulse responses of to a shock to debt-to-GDP ratio.

US government bonds exhibit many characteristics often attributed to safe assets: They are very liquid and lenders readily accept them as collateral. Indeed, a growing literature documents significant convenience yields, perhaps due to liquidity, in scarce US Treasuries, suggesting that rising Treasury supply and government debt comes with a declining liquidity premium and a fall in firms' relative cost of debt financing. In this paper, we empirically document and theoretically evaluate a dual role for government debt. Through a liquidity channel an increase in government debt improves liquidity and lowers liquidity premia by facilitating debt rollover, thereby reducing credit spreads. Through an uncertainty channel, however, rising government debt creates policy uncertainty, raising default risk premia. We interpret and quantitatively evaluate these two channels through the lens of a general equilibrium asset pricing model with risk-sensitive agents subject to liquidity shocks, in which firms issue defaultable bonds and the government issues tax-financed bonds that endogenously enjoy liquidity benefits. The calibrated model generates quantitatively realistic liquidity spreads and default risk premia, and suggests that while rising government debt reduces liquidity premia, it not only crowds out corporate debt financing, and therefore, investment, but also creates uncertainty reflected in endogenous tax volatility, credit spreads, and risk premia, and ultimately consumption volatility. Therefore, increasing safe asset supply can be risky.


Presented at the First Backus Memorial Conference in Ojai*, SED, the LBS Summer Finance Symposium, NBER Summer Institute Capital Markets, and CEPR Asset Pricing Summer Symposium in Gerzensee*, the Greater Bay Finance Conference, SHUFE Finance Conference, University of Zurich.