Capital Flows and the Making of Risky Currencies

Abstract

I show that currency risk is explained by the relative flightiness of foreign capital flows across countries’ external assets and liabilities. Foreign flows are “flighty”: foreign investors withdraw capital more aggressively than domestic investors in global drawdowns, with flightiness varying across asset classes and issuing countries. I develop a model in which a currency is risky when its external liabilities face flightier flows than its external assets. I construct “net asset flightiness”—external assets minus liabilities weighted by their asset-specific flightiness—and show it strongly correlates with currency risk in the cross-section.

Keywords: capital flows; currency risk;