Components of the Czech Koruna Risk Premium in a Multiple-Dealer FX Market

The paper proposes a continuous time model of an FX market organized as a multiple dealership. The model reflects a number of salient features of the Czech koruna spot market. The dealers have costly access to the best available quotes. They interpret signals from the joint dealer-customer order flow and decide upon their own quotes and trades in the inter-dealer market. Each dealer uses the observed order flow to improve the subjective estimates of the relevant aggregate variables, which are the sources of uncertainty. One of the risk factors is the size of the cross-border dealer transactions in the FX market. These uncertainties have diffusion form and are dealt with according to the principles of portfolio optimization in continuous time. The model is used to explain the country, or risk, premium in the uncovered national return parity equation for the koruna/euro exchange rate. The two country premium terms that I identify in excess of the usual covariance term (a consequence of the 'Jensen inequality effect') are the dealer heterogeneity-induced inter-dealer market order flow component and the dealer Bayesian learning component. As a result, a 'dealer-based total return parity' formula links the exchange rate to both the 'fundamental' factors represented by the differential of the national asset returns, and the microstructural factors represented by heterogeneous dealer knowledge of the aggregate order flow and the fundamentals. Evidence on the cross-border order flow dependence of the Czech koruna risk premium, in accordance with the model prediction, is documented.Bayesian learning, FX microstructure, optimizing dealer, uncovered parity.

Cross-border Risk Transmission by a Multinational Bank

A model of international banking, with the stress on the specific management human capital (borrower monitoring) and the majority shareholder human capital (manager auditing) is used to study the effects of exogenous shocks in one country on credit creation in the other. I show that the presence of the two named categories of non-transferable skills in the banking technology reduces the role of the standard portfolio diversification motive for cross-border transmission of disturbances. At the same time, this bank-specific market friction creates a separate channel of shock propagation, a function of the bank shareholder and manager incentives. It can even happen that the exogenous shock impact on credit has a different sign in the “relationship“ as opposed to “arm’s length“ banking environment. This phenomenon, caused by the marginal effect of the manager human capital involvement in the bank operation, is present in the bank branches with relatively small loan volumes. When the loan volume is large, the direction of the manager-auditing bank reaction to shocks abroad is the same as that of an arm’s length lender.multinational bank; managerial effort; audit; credit; foreign shock

Exchange rate risks and asset prices in a small open economy

The paper proposes a multi-factor international asset pricing model in which the exchange rate is allowed to be co-determined by a risk factor imperfectly correlated to other priced risks in the economy. The significance of this factor can be established as long as one is able to observe a proxy for the foreign cash order flow. Then, the asset pricing model is decomposed into the standard ICCAPM no-arbitrage setup characterized by a pricing kernel, in which, however, the “autarky” exchange rate is unobserved, and an additional equation that links this autarchic currency price with the FX order flow. The model is put in the state space form. The unobserved variables span the macroeconomic risk factors with an impact on the asset markets and determine the dynamics of the pricing kernel, the autarchic exchange rate and the FX order flow. A comparison of models allowing for an independent OF risk factor with a restricted one, where the forex order flow plays no role, should disclose the existence of a “nonfundamental” source of a systematic divergence of the observed and the autarchic (i.e. fundamental) FX returns. The model is calibrated and tested on the Czech koruna/euro exchange rate in a setting with seven Czech and euro area asset returns. JEL Classification: F31, F41, G12, G15exchange rate, latent risk, order flow, pricing kernel, state space

FOREX Microstructure, Invisible Price Determinants,and the Central Bank's Understanding of Exchange Rate Formation

The paper investigates the transmission of macroeconomic factors into the price-setting behavior of a specific dealer in the FX market. This problem is viewed from the perspective of a central banker who observes the price evolution but does not make the market in the home currency. The central banker's task is to explain the forex behavior in terms of conventional economic logic. The analysis is based on a model of a multiple dealer market under two organizations - direct inter-dealer and brokered. The model is constructed in such a way as to reflect the most prominent features of the market for the Czech koruna and, accordingly, to address some issues of key relevance to the Czech National Bank's exchange rate policy. We show that the totality of the exchange rate-relevant fundamental factors influence the market maker's behavior through a single sufficient statistic, his 'marginal' valuation of foreign currency holdings. Under the two studied trading mechanisms, the marginal valuations across market participants determine the equilibrium exchange rate by means of different trade patterns. Specifically, the brokered market is inferior to the direct one in terms of welfare improvement through trade. It takes a higher inter-dealer trade volume in the brokered market to absorb a new price impulse. Therefore, the central banker would do best by monitoring the brokered segment (as the only partially transparent one available), but by conducting interventions in the direct segment, where the desired impact is easier to achieve.forex microstructure, multiple dealership, order flow, pricing schedule.

Cross-Border Risk Transmission by a Multinational Bank

A model of international banking, with a stress on manager human-capital (borrower monitoring) and majority-shareholder human capital (manager auditing) is constructed to study the impact of exogenous shocks in one country on credit creation in another. I show that the presence of the two cited categories of non-transferable skills in banking technology reduces the role of the standard portfolio-diversification motive in the cross-border transmission of disturbances. At the same time, this bank-specific market friction creates a separate channel of shock propagation, a function of bank shareholder and manager incentives. It can even happen that the impact of an exogenous shock on credit has a different sign in the “relationship” as opposed to the “arm’s-length” banking environment. This phenomenon, caused by the marginal effect of the human-capital management in the bank operation, is present in those bank branches with relatively small loan volumes. When the loan volume is large, the direction of the reaction of the manager-auditing bank to shocks abroad is the same as that of an arm’s-length lender.multinational bank, managerial effort, audit, credit, foreign shock

Real Implications of Bursting Asset Price Bubbles in Economies with Bank Credit

We study the consequences of equity mispricing (a bubble) and the correction thereof (the bubble bursting) for real activity in a production economy. In our model, producers are financed by both bank debt and equity, and face a mix of systemic and idiosyncratic uncertainty. Positive/negative bubbles arise when prior public beliefs about the aggregate productivity of producers (business sentiment) become biased upwards/downwards. Economic activity in equilibrium is influenced by the bubble size in conjunction with agency problems caused by delegation of lending to relationship bankers. We explore the ability of a macroprudential policy instrument (a convex dependence of bank capital requirements on the quantity of uncollateralized credit) to dampen the consequences of a burst bubble. We find that macroprudential policies are more successful in suppressing equity price swings than moderating output fluctuations. At the same time, economic activity recoils substantially with the introduction of a macroprudential instrument, so that its presence is likely to entail tangible welfare costs. In this regard, fine-tuning capital charges as a function of corporate governance on the borrower side (specifically, by discouraging limited liability of borrowing firm managers) would be less costly than placing the full burden of prudential regulation on the lender side.bank, credit, asset price, bubble, macroprudential policy

Cross-Border Lending Contagion in Multinational Banks

We study the interdependence of lending decisions in different country branches of a multinational bank. This is done both theoretically and empirically. First, we formulate a model of a bank that delegates the management of its foreign unit to a local manager with non-transferable skills. The bank differs from other international investors due to a liquidity threshold which induces a depositor run and a regulatory action if attained. Therefore, lending decisions are influenced by delegation and precautionary motives. We then show that these two phenomena create a separate channel of shock propagation, a function of bank shareholder and manager incentives. The workings of this channel can lead to either “contagionâ€, meaning parallel reactions of the loan volumes in both countries to the parent bank home country disturbance, or standard “diversificationâ€, when the reactions of a standard international portfolio optimizer within the two country units go in opposite directions. In particular, it can happen that the impact of an exogenous shock on credit has a different sign in the “relationship†as opposed to the “arm’s-length†banking environment. Second, we construct a large sample of multinational banks and their branches/subsidiaries and look for the presence of lending contagion by panel regression methods. We obtain mixed results concerning contagion depending on the parent bank home country and the host economy of cross-border penetration. While the majority of multinational banks behave in line with the contagion effect, more than one-third do not. In addition, the presence of contagion seems to be related to the geographical location of subsidiaries.Delegation, diversification, lending contagion, multinational bank, panel regression.

Cross-border lending contagion in multinational banks

We study both theoretically and empirically the inter- dependence of lending decisions in different country branches of a multinational bank. First, we model a bank that delegates the management of its foreign unit to a local manager with non-transferable skills. The bank differs from other international investors due to a liquidity threshold which induces a depositor run and a regulatory action if attained. A separate channel of shock propagation exists since lending decisions are influenced by delegation and precautionary motives. This can entail “contagion”, i.e. parallel reactions of the loan volumes in both countries to the parent bank home country disturbance. Second, we look for the presence of lending contagion by panel regression methods in a large sample of multinational banks and their affiliates. We find that the majority of multinational banks behave in line with contagion effect. In addition, the presence of contagion seems to be related to the geographical location of subsidiaries. JEL Classification: F37, G21, G28, G31delegation, diversification, lending contagion, Multinational bank, panel regression

Predicting Bank CAMELS and S&P Ratings: The Case of the Czech Republic

In this paper we investigate the determinants of the movements in the long-term Standard & Poors and CAMELS bank ratings in the Czech Republic during the period when the three biggest banks, representing approximately 60% of the Czech banking sector's total assets, were privatized (i.e., the time span 1998-2001). The same list of explanatory variables corresponding to the CAMELS rating inputs employed by the Czech National Bank's banking sector regulators was examined for both ratings in order to select significant predictors among them. We employed an ordered response logit model to analyze the monthly long-run S&P rating and a panel data framework for the analysis of the quarterly CAMELS rating. The predictors for which we found significant explanatory power are: Capital Adequacy, Credit Spread, the ratio of Total Loans to Total Assets, and the Total Asset Value at Risk. Models based on these predictors exhibited a predictive accuracy of 70%. Additionally, we found that the verified variables satisfactorily predict the S&P rating one month ahead.Bank rating, CAMELS, ordered logit model, panel data analysis.

Macroeconomic Factors and the Balanced Value of the Czech Koruna/Euro Exchange Rate (in English)

The authors study the dependence of the Czech koruna’s exchange rate to the euro on risk factors that cannot be reduced to standard macroeconomic fundamentals. For this purpose, they construct an international asset-pricing model in which the exchange rate is codetermined by a risk factor imperfectly correlated with other priced risks in the economy. The model embeds the standard no-arbitrage setup. It also contains an additional equation that links the autarchic currency price with the foreign-exchange order flow. In the state-space form, the unobserved variables that determine the dynamics of the asset markets, the autarchic exchange rate, and the FX order flow span a number of macroeconomic and latent risk factors. The model for the Czech koruna/euro exchange rate uses Kalman filter techniques. The results indicate the existence of a “non-fundamental” source of systematic divergence between the observed and the autarchic (i.e. fundamental) FX returns.exchange rate, latent risk, order flow, pricing kernel, state space