Endogenous Global Risk

Abstract

The U.S. could be the source of the global financial risk because it longs risky assets and shorts safe assets in the international capital market. This paper builds a stylized two-country model to highlight that when the developed country's risk-bearing capacity improves, it holds more foreign risky assets and issue more risk-free debt. The foreign country's risk-bearing capacity is enhanced thanks to international risk sharing. Hence, the financial health of the developed country is the key driver behind the co-movement of global capital flow, asset price, risk premiums, and volatility, and the main variable affecting the valuation effects of its external positions and the financial contagion across countries. The risk-bearing capacity of the developing country, in turn, determines its supply of safe assets, whose fluctuation influences the demand for global safe assets and risk-free rates. We model a country's endogenously time-varying risk-bearing capacity in a continuous-time macro-finance framework featuring within-country heterogeneity and the equity financing constraint.

Keywords: global financial cycle, global imbalance, valuation effects, exorbitant privilege and duty, international risk sharing, global saving and risk-free rate, financial contagion

JEL Classification: F32, F34, F41,F44, G15