Seminar 217, Risk Management: Financial Frictions, Foreign Currency Borrowing, and Systemic Risk

Seminar: Risk Seminar | March 12 | 11 a.m.-12:30 p.m. | 1011 Evans Hall

 Speakers: Robert Marquez, UC Davis

 Consortium for Data Analytics in Risk

We present a novel explanation for the prevalence of foreign-currency borrowing in emerging markets. First, under limited liability, foreign-currency denominated debt acts as a state-contingent claim: Borrowers maximizing profits in local currency are partly shielded from large devaluations through bankruptcy, when repaying foreign currency debt is expensive, but pay higher rates in non-devaluation states, when repayment is relatively cheaper. Second, foreign- currency borrowing can improve firms’ incentives and reduce agency problems at the cost of higher systemic risk. The resulting trade-off between average performance and systemic stability, which becomes stronger when bankruptcies entail externalities, lends support to regulation limiting currency mismatches.