The Role of Bond Markets When Portfolio Choice is Constrained

We develop a two-country international asset pricing model in which some investors face leverage constraints. In contrast to models with a single `world' bond, we show that tightening regulation can lead to the risk free interest rate rising. When demand for borrowing is high, a tightening of the constraint causes the investor to shift his loans from international more into local bond markets, putting upwards pressure on local interest rates. Indeed, he sacrifices diversification to gain more risk exposure, by under diversifying currency risk through international bonds. Exchange rate dynamics give rise to a currency risk premium, making carry trades profitable - even in the benchmark unconstrained economy. Consistent with empirical findings, a sudden binding of constraints can significantly shift exchange rate dynamics, rendering previously set up carry trades unprofitable.