Essays on international finance and asset pricing

Abstract

This thesis consists of three essays on international finance and asset pricing. In the first essay, we examine the effect of capital control policies from a new perspective which is currency risk and return. We find that currencies of emerging markets with stricter capital controls exhibit lower average returns, the return spreads of which cannot be explained by traditional currency risk factors or country characteristics. We also show that this negative effect of capital controls is concentrated in debtor countries and is not present in advanced economies. Moreover, the high-capital-control currencies depreciate less in times of high global risk, which is consistent with the macroprudential view of capital controls. An equilibrium intermediary based asset pricing model is proposed where a country borrows subject to an occasionally binding collateral constraint. Our model predicts that capital controls can reduce the crises probability and mitigate the currency crashes in crisis times, which quantitatively accounts for the empirical findings. In the second essay, I relate bank regulations to intermediary asset pricing with an involvement of the FX swap market. I document that stronger regulations enhance the role of global banks as marginal investors in the local asset markets. After the Global Financial Crisis, the leverage of global banks significantly predicts asset returns in local markets where their subsidiaries are located, while there is no predictability in the pre-crisis period. I show empirically that this transition of the role of global banks is motivated by the funding advantage in local currency for dollar lenders through the FX swap market as a consequence of tighter balance sheet constraints imposed on global banks under the Basel III framework. For global banks with higher capital requirement, the effect of funding advantage is stronger. A two-bank two-currency model is proposed to reconcile the empirical findings. In the third essay, we establish that two factors, dollar and carry, suffice to explain a rich cross- section of currency returns, through a parsimonious framework to estimate conditional currency factor models which provides testable restrictions. We highlight the importance of accounting for time-variation in conditional moments when estimating currency factor models. Unconditional estimations that ignore this time-variation mistakenly reject the two-factor model. Our results imply that currency markets are well described by a model in which (i) each country-specific SDF loads on one country-specific—dollar—and one global—carry—shock, and (ii) risk loadings are time-varying. Other popular factors in the literature do not necessitate additional shocks in the model. Instead, they describe the time variation in dollar and carry factor risk premia.