Why are Countries' Asset Portfolios Exposed to Nominal Exchange Rates?

Abstract

Most countries hold large gross asset positions, lending in domestic currency and borrowingin foreign. Thus, their balance sheets are exposed to nominal exchange rates. We argue thatwhen asset markets are incomplete, nominal exchange rate exposure allows countries topartially insure against shocks that move real exchange rates. We demonstrate that assetmarket incompleteness can simultaneously generate realistic gross asset positions and resolvethe Backus-Smith puzzle: that relative consumptions and real exchange rates correlatenegatively. We also show that local perturbation methods that use stabilizing endogenousdiscount factors are inaccurate when average and steady state interest rates differ. To addressthis, we develop a novel global solution method to accurately solve the model.