International Reserves and the Equity Premium

Orientador(a): Carlos Viana de Carvalho

Co-orientador(a): Eduardo Zilberman

Insurance is a possible explanation for the large holdings of international reserves observed in many countries. Quantitative models of the insurance motive, however, struggle to rationalize reserve positions, unless agents exhibit relatively high levels of risk aversion. This result suggests a connection between the "international reserves puzzle" and the "equity premium puzzle", which I explore in this paper. I introduce Epstein-Zin preferences into a standard sovereign default model with long-term debt and a risk-free asset, and calibrated it to the Mexican economy. I then price an equity claim within the model, and use simulations to establish a positive relationship between optimal reserve holdings and the equity premium, as I vary the degree of risk aversion of domestic agents. Using an estimate of the equity premium for Mexico, I calibrate the level of risk aversion and find it produces an optimal level of international reserves that is close to the data. Finally, I provide empirical evidence consistent with the relationship established with the model. Specifically, I introduce estimates of the equity premium into standard regressions used to explain countries' holdings of international reserves. Using both cross-sectional and panel specifications, I document a robust positive association between these two variables.