Xiang Fang

This paper studies how time-varying volatility drives exchange rates through financial intermediaries’ risk management. We propose a model where currency market participants are levered intermediaries subject to value-at-risk constraints. Higher volatility translates into tighter financial 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, the exchange rate volatility puzzle, and generate deviations from covered interest rate parity. Our empirical tests verify model implications that volatility and financial constraint tightness predict exchange rates.

We provide a global solution method for a class of macroeconomic models featuring nonlinear dynamics and compare the global method with first order, second order, and occasionally binding local perturbation methods. This class of models includes macroeconomic models for unconventional monetary policies with financial intermediaries. Within this framework, we show that the solving the model globally is essential for policy function and impulse response analysis when the intermediary's financial constraint only binds occasionally, and when risk plays an important role in the economy. We also present an economy in which local methods fail when there does not exist a steady state with binding constraint.

This paper offers novel evidence on the impact of raising bank capital requirements in the context of an emerging market: Peru. Using quarterly bank-level data and exploiting the adoption of bank-specific capital buffers, we find that higher capital requirements have a short-lived, negative impact on bank credit in Peru, although this effect becomes statistically insignificant in about half a year. This finding is robust to estimating different specifications to address concerns about the exogeneity of capital requirements. The fact that the reform was gradual and pre-announced and that banks were highly profitable at the time could explain the short-lived effects on credit.