Template-Type: ReDIF-Paper 1.0
Title: Dominant Currency Pricing and Currency Risk Premia
Author-Name: Husnu C. Dalgic
Author-Email: dalgic@uni-mannheim.de 
Author-Name: Galip Kemal Ozhan
Author-Email: gozhan@gmail.com

Classification-JEL: E44, F32, F41, G15, G21.

Keywords: Currency returns, dominant currency pricing, uncovered interest parity,
inflation, dollar debt.

Abstract: This paper argues that currency risk premia are an endogenous outcome of a country’s fundamental trade and financial structures. Empirically, we isolate global
risk factors from currency returns and show that a country’s exposure to these factors is jointly determined by its share of dollar invoicing and its net foreign
debt position. We then develop a small open-economy model with dominant-currency pricing (DCP) and dollar-denominated liabilites to explain the underlying
mechanism. The model demonstrates that empirically plausible risk premia require the interaction of both frictions. High dollar invoicing mutes the expenditure switching channel, 
while high dollar debt creates a potent, contractionary financial channel. Together, these frictions make currency depreciations recessionary
(countercyclical), rendering the currency a poor hedge and "risky" for investors. We show this has a first-order policy consequence: the resulting risk premium
raises the economy’s neutral interest rate, leading to structurally high inflation under a standard Taylor rule. Our results show how trade and financial frictions
jointly create currency risk and pose a fundamental challenge for monetary policy


Note: 
Length: 60
Creation-Date: 2025-12
Revision-Date: 
File-URL: https://www.crctr224.de/research/discussion-papers/archive/dp717
File-Format: application/pdf
Handle: RePEc:bon:boncrc:CRCTR224_2025_717