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.

Fire Sales in a Model of Complexity

Published: 08/12/2013   |   DOI: 10.1111/jofi.12087

RICARDO J. CABALLERO, ALP SIMSEK

We present a model of financial crises that stem from endogenous complexity. We conceptualize complexity as banks' uncertainty about the financial network of cross exposures. As conditions deteriorate, cross exposures generate the possibility of a domino effect of bankruptcies. As this happens, banks face an increasingly complex environment since they need to understand a greater fraction of the financial network to assess their own financial health. Complexity dramatically amplifies banks' perceived counterparty risk, and makes relatively healthy banks reluctant to buy risky assets. The model also features a novel complexity externality.

Monetary Policy and Asset Price Overshooting: A Rationale for the Wall/Main Street Disconnect

Published: 04/12/2024   |   DOI: 10.1111/jofi.13343

RICARDO J. CABALLERO, ALP SIMSEK

We analyze optimal monetary policy and its implications for asset prices when aggregate demand has inertia. If there is a negative output gap, the central bank optimally overshoots aggregate asset prices (above their steady‐state levels consistent with current potential output). Overshooting leads to a temporary disconnect between the performance of financial markets and the real economy, but accelerates the recovery. When there is a lower bound constraint on the discount rate, good macroeconomic news is better news for asset prices when the output gap is more negative. Finally, we document that during the COVID‐19 recovery, the policy‐induced overshooting was large.