Optimal Bond Holding Dynamics with Hedging Motives Against Real Exchange Rate Risks

Abstract

This study examines optimal bond holding dynamics using a two-country DSGE model with two bonds. Unlike previous studies focusing on steady-state properties of optimal bond holdings, we solve the model by employing a third-order approximation method and show how optimal bond holdings respond when macro fundamentals change. In particular, we derive impulse responses of optimal home and foreign bond holdings to productivity shocks. Simulation results show that with a positive productivity shock at home, optimizing home agents decrease holdings of home bonds and increase holdings of foreign bonds. Correlation between relative price and excess bond returns following a positive productivity shock makes home (foreign) bond a less (more) attractive hedging tool against real exchange rate risks. In addition, we use a SVAR method and verify that the optimal bond holding dynamics derived from the model are observed in the data.

Keywords: Hedge ratio, real exchange rate risk, DSGE model, higher order approximation, SVAR