Currency Risk Premia and Unhedged, Foreign-Currency Borrowing in Emerging Markets

This paper develops an analytical framework to jointly rationalize two important unresolved puzzles in international economics: the generation of currency risk premia in the interest rates of many emerging markets, and the desire of firms in these environments to expose themselves to currency risk by denominating their debt, unhedged, in foreign-currency. In contrast to the extant theoretical literature, we focus on the asymmetry of national monies to demonstrate how foreign-currency assets can often serve as consumption hedges to households in emerging markets, who then demand a risk-premium to hold domestic-currency-denominated assets. The portfolio diversification decisions of firms, in turn, reveals that risk–averse firms in emerging economies are inclined to undertake foreign-currency liabilities for variance-minimizing purposes and, in the presence of a risk premium, for speculative purposes. Differentiating between these opposing motives is crucial from the standpoint of assessing firm vulnerability to unanticipated currency movements. We are thus able to show that, contrary to conventional wisdom, unhedged, foreign-currency debt can arise even in the absence of any bailout guarantees and the associated moral hazard. Finally, combining the different portfolio demands, we can solve for the equilibrium premium in terms of the economy’s parameters, including the current account deficit, relative net-worth of the nontradable and tradable sectors, volatility of the exchange rate and the extent to which nominal depreciations translate into real depreciations. Our analysis reveals that—contrary to conventional wisdom—increased exchange rate uncertainty may not necessarily reduce the desire of firms to take on risky, foreign-currency debt.