Essays in International Finance The Harvard community has made this article openly available

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Essays in International Finance
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Du, Wenxin. 2013. Essays in International Finance. Doctoral dissertation, Harvard University.
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Essays in International Finance
Adissertationpresentedby
WenxinDu
to
TheDepartmentofEconomics
inpartialfulfillmentoftherequirements
forthedegreeof
DoctorofPhilosophy
inthesubjectof
Economics
HarvardUniversity
Cambridge,Massachusetts
May2013
c 2013—WenxinDu
￿
Allrightsreserved.
DissertationAdvisors: JohnY.Campbell,GitaGopinath WenxinDu
EssaysinInternationalFinance
ABSTRACT
This dissertation consists of three essays in international finance. The first two essays study
emerging market sovereign risk with a focus on local currency denominated sovereign bonds.
Thethirdessayexamineseconometrictoolsforrobustinferenceinthepresenceofmissingobser-
vations,anissuefrequentlyencounteredbyresearchersininternationalfinance.
Mostemergingmarketsovereignborrowingisnowdenominatedinlocalcurrencies. InChap-
ter1,weintroduceanewmeasureofsovereignrisk,thelocalcurrencycreditspread,definedasthe
syntheticdollarspreadonalocalcurrencybondafterusingcrosscurrencyswapstohedgethecur-
rency risk of promised cash flows. Compared with traditional sovereign risk measures based on
foreigncurrencydenominateddebt,wefindthatlocalcurrencycreditspreadshavelowermeans,
lowercross-countrycorrelations,andarelesssensitivetoglobalriskfactors. Werationalizethese
findingswithamodelallowingfordifferentdegreesofintegrationbetweendomesticandexternal
debtmarkets.
Chapter 2 documents new empirical evidence on the rapid growth of foreign ownership of
emerging market local currency sovereign debt over the past decade. We study risk of nominal
bondswithouthedgingawaythecurrencyrisk. Weshowthatlocalcurrencynominalbondrisks
differ across countries and are highly correlated with sovereign credit default swap spreads on
foreigncurrencyexternaldebt. Usingdataoninvestors’forecastsofinflationandgrowth,wefind
that perceived differences in the cyclicality of monetary policy help explain the cross-sectional
and time series variation in nominal bond risk as well as the development of local currency debt
markets. Guidedbytheseobservedempiricalpatterns, wedevelopasimplegeneralequilibrium
modelwithanendogenousissuancedecisionbetweenlocalandforeigncurrencydebt.
Chapter3proposestwosimpleconsistentheteroskedasticityandautocorrelationconsistentco-
varianceestimatorsfortimeserieswithmissingdata. First,wedeveloptheAmplitudeModulated
iii
estimator by applying the Newey-West estimator and treating the missing observations as non-
serially correlated. Secondly, we develop the Equal Spacing estimator by applying the Newey-
West estimator to the series formed by treating the data as equally spaced. We show asymptotic
consistencyofbothestimatorsforinferencepurposesanddiscussfinitesamplevarianceandbias
tradeoff.
iv
TABLEOFCONTENTS
Abstract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iii
Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix
1. LocalCurrencySovereignRisk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1.1 RelationtotheLiterature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.2 CrossCurrencySwapsandSovereignCreditSpreads . . . . . . . . . . . . . . . . . . 8
1.2.1 CrossCurrencySwaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.2.2 LCandFCCreditSpreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.3 NewStylizedFactsonLCSovereignRisk . . . . . . . . . . . . . . . . . . . . . . . . . 12
1.3.1 DeviationsfromLong-TermCIP . . . . . . . . . . . . . . . . . . . . . . . . . . 12
1.3.2 MeanLevelsofCreditSpreads . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
1.3.3 WideningCreditSpreadDifferentialsDuringtheCrisis . . . . . . . . . . . . . 19
1.3.4 Cross-CountryCorrelationsofCreditSpreads . . . . . . . . . . . . . . . . . . 20
1.3.5 CorrelationofSovereignRiskwithGlobalRiskFactors . . . . . . . . . . . . . 22
1.3.6 SummaryofStylizedFacts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
1.4 ANo-ArbitrageModelwithRiskyCreditArbitrage . . . . . . . . . . . . . . . . . . . 26
1.4.1 DifferentialCashFlowRiskandInvestorBases . . . . . . . . . . . . . . . . . . 26
1.4.2 Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
1.4.3 PricingFCandLCBonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
1.4.4 ComparativeStatics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
1.4.5 EmpiricalDecompositionofCreditSpreadDifferentials . . . . . . . . . . . . 35
1.5 DifferentialRiskPremia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
1.5.1 BenchmarkRegressions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
1.5.2 Cross-CountryVariation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
1.5.3 ExcessReturnsPredictability . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
1.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
2. TheEndof“OriginalSin”: NominalBondRiskinEmergingMarkets . . . . . . . . . . . . . . . 49
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
2.2 RelatedLiterature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
2.3 TheEndof“OriginalSin” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
2.4 MeasuringNominalBondRisks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
2.4.1 DefinitionofNominalBondBetas . . . . . . . . . . . . . . . . . . . . . . . . . 59
2.4.2 Cross-countryVariationsinNominalBondRisk . . . . . . . . . . . . . . . . . 61
2.5 WhatExplainsNominalBondRisk? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
2.5.1 BondBetasandSovereignCDSSpreads . . . . . . . . . . . . . . . . . . . . . 64
2.5.2 CyclicalityofInflationExpectation . . . . . . . . . . . . . . . . . . . . . . . . . 65
v
2.6 ImplicationsofNominalRiskonSovereignPortfolios . . . . . . . . . . . . . . . . . . 67
2.7 GeneralEquilibriumModelofSovereignPortfolioChoice. . . . . . . . . . . . . . . . 69
2.7.1 TheoreticalFramework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
2.7.2 SecondPeriodProblem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
2.7.3 FirstPeriodProblem: ExternalDebtOnly . . . . . . . . . . . . . . . . . . . . . 75
2.8 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
3. NonparametricHACEstimationforTimeSeriesDatawithMissingObservations . . . . . . . . 84
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
3.1.1 RelationtotheLiterature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
3.2 Asimpleexample . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
3.3 Long-RunVarianceofTimeSerieswithMissingObservations . . . . . . . . . . . . . 92
3.3.1 MissingDataStructure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
3.3.2 Newey-WestEstimator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
3.3.3 Long-RunVarianceoftheUnderlyingProcess-ParzenEstimator . . . . . . . 94
3.3.4 Long-RunVarianceoftheObservedProcess . . . . . . . . . . . . . . . . . . . 95
3.3.5 FiniteSamples. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
3.4 RegressionModelwithMissingObservations . . . . . . . . . . . . . . . . . . . . . . . 101
3.5 Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
3.5.1 DataStructure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
3.5.2 EvaluationCriteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
3.5.3 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
3.6 EmpiricalApplication: RecursiveTestsforaPositiveSampleMean . . . . . . . . . . 116
3.7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
Appendix 125
A. AppendixtoChapter1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
A.1 AReal-WorldExample . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
A.2 YieldCurveConstruction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
A.3 N-PeriodExtension . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
A.3.1 Risk-FreeRates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
A.3.2 FCBonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
A.3.3 LCBonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
vi
LISTOFTABLES
1.1 MeanLCandFCCreditSpreadComparison,2005-2011. . . . . . . . . . . . . . . . . 18
1.2 ChangesinCreditSpreadsDuringCrisisPeak(09/01/08-09/01/09). . . . . . . . . 20
1.3 Cross-CountryCorrelationofCreditSpreads,2005-2011. . . . . . . . . . . . . . . . . 21
1.4 Cross-CountryCorrelationofCreditSpreads,2005-2011. . . . . . . . . . . . . . . . . 22
1.5 RegressionsofBondExcessReturnsonEquityReturns,2005-2011. . . . . . . . . . . 25
1.6 Regressionof5-YearCreditSpreadsonVIX,2005m1-2011m12. . . . . . . . . . . . . . 40
1.7 ImpactofVIXonCreditSpreadsbyCountry. . . . . . . . . . . . . . . . . . . . . . . . 43
1.8 ForecastingQuarterlyHolding-PeriodExcessReturns,2005m1-2011m12. . . . . . . . 46
2.1 EquityandBondExcessReturnCorrelationwithU.S.Markets(2005-2012).. . . . . . 62
2.2 FixedCouponLCDebtasaFractionofDomesticDebt. . . . . . . . . . . . . . . . . . 68
2.3 FixedCouponLCDebtasaFractionofTotalSovereignDebt. . . . . . . . . . . . . . . 69
3.1 DailyGasolinePrices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
3.2 DailyGasolinePriceswithMissingObservations. . . . . . . . . . . . . . . . . . . . . 91
3.3 BenchmarkResults. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
3.4 VaryingMissingStructure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
3.5 FiniteSamples: FixedandAutomaticBandwidthSelection. . . . . . . . . . . . . . . . 111
3.6 EmpiricalBiasandVariance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
3.7 AutomaticallySelectedBandwidths. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
3.8 VaryingFractionofMissings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
3.9 RejectionRatesforRecursiveTests. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
A.1 Cross-CurrencySwapsandCurrencyForwardComparison,2005-2011. . . . . . . . . 132
A.2 HalfofBid-askSpreadsonFXSpots,ForwardsandSwaps,2005-2011. . . . . . . . . 133
A.3 DataSourcesandVariableConstruction. . . . . . . . . . . . . . . . . . . . . . . . . . . 134
vii
LISTOFFIGURES
1.1 OffshoreTradingVolumebyInstrumentTypes(TrillionsofUSD). . . . . . . . . . . . 3
1.2 CumulativeFlowsofOffshoreEmergingMarketFunds(BillionsofUSD) . . . . . . . 4
1.3 5-YearU.S.andSwappedUKTreasuryYieldsinpercentagepoints. . . . . . . . . . . 12
1.4 5-YearSwappedLCandFCSpreadsinpercentagepoints.. . . . . . . . . . . . . . . . 14
1.4 (Continued)5-YearSwappedLCandFCSpreadsinpercentagepoints. . . . . . . . . 15
1.5 BrazilOnshoreandOffshoreYieldComparison. . . . . . . . . . . . . . . . . . . . . . 17
1.6 SwappedLCoverFCspreads. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
1.7 5-YearSovereignCreditSpreadsinItaly. . . . . . . . . . . . . . . . . . . . . . . . . . . 36
1.8 5-YearSovereignCreditSpreadsinRussia. . . . . . . . . . . . . . . . . . . . . . . . . 36
1.9 DifferentialRiskAversionPass-ThoughandReturnCorrelation. . . . . . . . . . . . . 42
2.1 ForeignOwnershipofGovernmentDebtinEmergingandDevelopedMarkets. . . . 55
2.2 TimeSeriesofForeignOwnershipofGovernmentDebtinEmergingMarkets. . . . . 56
2.3 OwnershipofDomesticDebtbySecurityTypein2012. . . . . . . . . . . . . . . . . . 57
2.4 OwnershipStructureofPeruvianNominalBonds(millionsofnuevosoles). . . . . . 58
2.5 Local,GlobalandCurrencyBetas(2005-2012). . . . . . . . . . . . . . . . . . . . . . . 63
2.6 BondBetasandSovereignCDSSpreads. . . . . . . . . . . . . . . . . . . . . . . . . . . 65
2.7 ForecastBetaandBondBeta. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
2.8 InflationandDefaultPolicyFunctions. . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
2.9 ShareofLCDebtvs. AmountofRevenueRaised. . . . . . . . . . . . . . . . . . . . . 77
2.10 ExpectedInflationandDefaultforEquilibriumPortfolios. . . . . . . . . . . . . . . . 78
2.11 TheRoleofRiskPremium. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
2.12 ShareofLCExternalFinancingwithEndogenousOutput. . . . . . . . . . . . . . . . 82
2.13 InflationandDefaultwithDomesticFinancing. . . . . . . . . . . . . . . . . . . . . . . 82
3.1 TimeSeriesofReturns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
3.2 RecursiveTestResults-SampleMeanandErrorBands. . . . . . . . . . . . . . . . . . 122
3.3 BackwardsRecursiveTestResults-SampleMeanandErrorBands. . . . . . . . . . . 123
A.1 AnIllustrationofSwapCoveredLocalCurrencyInvestment. . . . . . . . . . . . . . . 131
viii
ACKNOWLEDGMENTS
IowesincereandearnestthankfulnesstomythesisadvisorsJohnY.Campbell,GitaGopinath
andLuisM.Viceirafortheirinvaluablehelpandguidance. IcannotthankJohnenoughforbeing
a conscientious mentor and role model, who has inspired and nurtured my interests in financial
economics. I am tremendously grateful to Gita for nurturing my scholarship over years, and
going above and beyond for me throughout the job market process. This work would not have
been possible without her brilliance and generosity of time and resources. I am also extremely
thankful to Luis for his constant enthusiasm and encouragement. His knowledge and insights
havebeenindispensableforallmyprogress.
I am grateful to James Stock and Rustam Ibragimov for their insightful guidance in draft-
ing Chapter 3 of this dissertation. I am also grateful to my co-authors Jesse Schreger and Deepa
DhumeDatta. Theirinspirationanddedicationhavebeeninstrumentaltothequalityofmywork.
I also thank Javier Bianchi, Fernando Broner, Gary Chamberlain, Emmanuel Farhi, Jeffrey
Frankel, Jeffry Frieden, Robin Greenwood. Ricardo Hausman, Jakub Jurek, Sebnem Kalemli-
Ozcan, Hanno Lustig, Matteo Maggiori, Ulrich Mueller, Jose Luis Montiel, Michael Rashes, Ken-
neth Rogoff, Jeremy Stein, Adrien Verdelhan and seminar participants at AQR Capital Manage-
ment,FederalReserveBoard,Harvard,Maryland,NBERIFMMeeting,StanfordGSB,UCLAAn-
derson, Penn Wharton, UCSD, UVA Darden and World Bank for comments and suggestions. I
thank Harvard Graduate Student Fellowship and the International Economics Grant for provid-
ingfinancialsupportformyresearch.
I deeply appreciate my friends and fellow classmates, Jisoo Hwang and Anitha Sivasankaran
with whom I seldom talk economics, for being able to share in all the joys and challenges of
graduate school and life. On the subject of graduate school life, I owe much to Brenda Piquet.
Everythingwouldnotbeasseamlesswithouthersupport.
IamindebtedtomybestfriendsfromSwarthmore,QingLing,BoHuandYijunLi,forspend-
ing countless hours helping me find the right data, sharing their perspectives as financial practi-
ix