Abstract
This paper proposes a novel mechanism through which currency risk is determined by foreign capital flows. As an empirical fact, foreign capital flows are “flighty”: they are more sensitive to macroeconomic and financial news than are domestic flows. Analyses of global mutual fund data reveal that foreign flightiness cannot be fully explained by currency risk or investor types, and is partially driven by retail fund investors. This paper proposes an origin of flighty capital flows based on heterogeneous beliefs between foreign and domestic investors, and provides supportive evidence. Informed by these empirical findings, this paper develops a model in which flighty capital flows induce currency risk. The model features international portfolio choices with heterogeneous beliefs and exchange rate dynamics driven by capital flows. In the model, currency risk is determined by the relative flightiness between foreign investors’ holdings of domestic assets (external liabilities) vs. domestic investors’ holdings of foreign assets (external assets). A currency is risky if the country’s external liabilities are subject to flightier flows than its external assets. The relative flightiness can be captured by a new measure, termed “net asset flightiness”, based on a country’s external balance sheet composition. This measure is constructed as the difference between external assets and liabilities, each weighted by their specific flightiness. In the data, net asset flightiness exhibits strong correlations with common measures of currency risk.

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