Currency Risks in International Financial Markets. International Finance Section

The relative riskiness of holding foreign currency under flexible and fixed exchange-rate regimes has always been a major consideration when the costs and benefits of each regime have been compared. Interest has centered on risk because of its welfare implications and its effect on the efficiency of stabilization policies. One important concern is that the costs of financing international trade increase if investors and traders consider it risky to hold foreign currencies, making the international division of labor less efficient. Two other concerns relate to the efficiency of international capital markets. First, an exchange-rate regime may cause welfare losses if real rates of return differ on similar investments in different countries because of the riskiness of holding foreign currencies. Second, an exchange-rate regime may limit the opportunity to diversify portfolios so as to minimize exposure to currency risks. A particular level of risk need not be inherent in an exchange-rate regime: it may be the deliberate result of central -bank policies. The target of minimizing risk may conflict with other policy considerations. Such a conflict occurs, for example, when the central bank tries to control the real rate of interest on domestic financial assets. The bank\u27s ability to do so is largely determined by the degree of substitutability of domestic and foreign assets. By adopting an exchange-rate regime that increases currency risks, the central bank can decrease the substitutability of assets denominated in different currencies and thereby increase the effectiveness of monetary policy. There is thus ample reason to study the size and nature of the risks associated with international borrowing and lending under different exchange-rate regimes and to determine the extent to which the risks under these regimes are subject to control by monetary authorities. The purpose of this study is to try to clarify the issues by analyzing (a) how the risks of investing in alternative currencies can be described; (b) how the size and the nature of the risks depend on the exchange-rate regime and on the behavior of the monetary authority under each regime; and (c) how risks and changes in the levels of risk affect the behavior of investors. At issue is whether an investor\u27s response to changes in rates of return or risks somehow depends on the exchange-rate regime