Capital Flows and the Making of Risky Currencies

Abstract

A currency is considered risky if it depreciates during downturns. I show that currency risk is caused by foreign capital flows induced by heterogeneous responses of foreign and domestic investors to global shocks. I establish that foreign flows are “flighty”: foreign investors withdraw capital in response to negative news. Empirically, currency risk appears to play a limited role at most in driving this flightiness. However, consistent with an explanation based on heterogeneous beliefs, I find that foreign forecasts react more strongly to news, and their returns are relatively lower. Motivated by these findings, I develop a model in which foreign investors update their beliefs more strongly to negative shocks, creating flighty foreign flows. In the model, the relative flightiness of a country's external liabilities and external assets determines its currency risk. That is, if foreign holdings of domestic assets respond more to global shocks than do domestic holdings of foreign assets, the country's currency is risky (and vice versa for safe currencies). Based on this, I construct a model-informed measure, “net asset flightiness”—the difference between external assets and liabilities weighted by their specific flightiness, which I show strongly correlates with currency risk.

Keywords: capital flows; currency risk;