The Journal of Finance

Excessive Dollar Debt: Financial Development and Underinsurance

Published: 03/21/2003   |   DOI: 10.1111/1540-6261.00549

Ricardo J. Caballero, Arvind Krishnamurthy

We propose that the limited financial development of emerging markets is a significant factor behind the large share of dollar‐denominated external debt present in these markets. We show that when financial constraints affect borrowing and lending between domestic agents, agents undervalue insuring against an exchange rate depreciation. Since more of this insurance is present when external debt is denominated in domestic currency rather than in dollars, this result implies that domestic agents choose excessive dollar debt. We also show that limited financial development reduces the incentives for foreign lenders to enter emerging markets. The retarded entry reinforces the underinsurance problem.

Collective Risk Management in a Flight to Quality Episode

Published: 09/10/2008   |   DOI: 10.1111/j.1540-6261.2008.01394.x

RICARDO J. CABALLERO, ARVIND KRISHNAMURTHY

Severe flight to quality episodes involve uncertainty about the environment, not only risk about asset payoffs. The uncertainty is triggered by unusual events and untested financial innovations that lead agents to question their worldview. We present a model of crises and central bank policy that incorporates Knightian uncertainty. The model explains crisis regularities such as market‐wide capital immobility, agents' disengagement from risk, and liquidity hoarding. We identify a social cost of these behaviors, and a benefit of a lender of last resort facility. The benefit is particularly high because public and private insurance are complements during uncertainty‐driven crises.

Limits of Arbitrage: Theory and Evidence from the Mortgage‐Backed Securities Market

Published: 03/20/2007   |   DOI: 10.1111/j.1540-6261.2007.01217.x

XAVIER GABAIX, ARVIND KRISHNAMURTHY, OLIVIER VIGNERON

“Limits of Arbitrage” theories hypothesize that the marginal investor in a particular asset market is a specialized arbitrageur rather than a diversified representative investor. We examine the mortgage‐backed securities (MBS) market in this light. We show that the risk of homeowner prepayment, which is a wash in the aggregate, is priced in the MBS market. The covariance of prepayment risk with aggregate wealth implies the wrong sign to match the observed prices of prepayment risk. The price of risk is better explained by a kernel based on MBS market‐wide specific risk, consistent with the specialized arbitrageur hypothesis.

Foreign Safe Asset Demand and the Dollar Exchange Rate

Published: 02/02/2021   |   DOI: 10.1111/jofi.13003

ZHENGYANG JIANG, ARVIND KRISHNAMURTHY, HANNO LUSTIG

We develop a theory that links the U.S. dollar's valuation in FX markets to the convenience yield that foreign investors derive from holding U.S. safe assets. We show that this convenience yield can be inferred from the Treasury basis, the yield gap between U.S. government and currency‐hedged foreign government bonds. Consistent with the theory, a widening of the basis coincides with an immediate appreciation and a subsequent depreciation of the dollar. Our results lend empirical support to models that impute a special role to the United States as the world's provider of safe assets and the dollar as the world's reserve currency.

Sizing Up Repo

Published: 04/08/2014   |   DOI: 10.1111/jofi.12168

ARVIND KRISHNAMURTHY, STEFAN NAGEL, DMITRY ORLOV

To understand which short‐term debt markets experienced “runs” during the financial crisis, we analyze a novel data set of repurchase agreements (repo), that is, loans between nonbank cash lenders and dealer banks collateralized with securities. Consistent with a run, repo volume backed by private asset‐backed securities falls to near zero in the crisis. However, the reduction is only $182 billion, which is small relative to the stock of private asset‐backed securities as well as the contraction in asset‐backed commercial paper. While the repo contraction is small in aggregate, it disproportionately affected a few dealer banks.

Measuring Liquidity Mismatch in the Banking Sector

Published: 10/10/2017   |   DOI: 10.1111/jofi.12591

JENNIE BAI, ARVIND KRISHNAMURTHY, CHARLES‐HENRI WEYMULLER

This paper constructs a liquidity mismatch index (LMI) to gauge the mismatch between the market liquidity of assets and the funding liquidity of liabilities, for 2,882 bank holding companies over 2002 to 2014. The aggregate LMI decreases from +$4 trillion precrisis to −$6 trillion in 2008. We conduct an LMI stress test revealing the fragility of the banking system in early 2007. Moreover, LMI predicts a bank's stock market crash probability and borrowing decisions from the government during the financial crisis. The LMI is therefore informative about both individual bank liquidity and the liquidity risk of the entire banking system.

Mortgage Design in an Equilibrium Model of the Housing Market

Published: 07/14/2020   |   DOI: 10.1111/jofi.12963

ADAM M. GUREN, ARVIND KRISHNAMURTHY, TIMOTHY J. MCQUADE

How can mortgages be redesigned to reduce macrovolatility and default? We address this question using a quantitative equilibrium life‐cycle model. Designs with countercyclical payments outperform fixed payments. Among those, designs that front‐load payment reductions in recessions outperform those that spread relief over the full term. Front‐loading alleviates liquidity constraints when they bind most, reducing default and stimulating housing demand. To illustrate, a fixed‐rate mortgage (FRM) with an option to convert to adjustable‐rate mortgage, which front‐loads payment reductions relative to an FRM with an option to refinance underwater, reduces price and consumption declines six times as much and default three times as much.