Financial amplification of foreign exchange risk premia

Theories of financial frictions in international capital markets suggest that financial intermediaries' balance sheet constraints amplify fundamental shocks. We present empirical evidence for such theories by decomposing the U.S. dollar risk premium into components associated with macroeconomic fundamentals, and a component associated with financial intermediary balance sheets. Relative to the benchmark model with only macroeconomic state variables, balance sheets amplify the U.S. dollar risk premium. We discuss applications to financial stability monitoring.