Understanding bilateral exchange rate risks

• We estimate volatility and jump risks of bilateral exchange rates of 31 countries by ARJI model.
• We explore the determinants of bilateral exchange rate risks utilizing panel estimation.
• External financial liabilities negatively affect bilateral exchange rate risks.
• The development of domestic financial sectors will attenuate the negative effect.
• The balance sheet effect is the channel through which financial variables exert effects.

We apply the autoregressive conditional jump intensity (ARJI) model to weekly bilateral exchange rate returns of 31 countries and examine the determinants of bilateral exchange rate risks over the period 2001–2013. Consistent with the balance sheet effects in the open economy literature, we find that bilateral exchange rate risks are significantly reduced by external financial liabilities, above and beyond the standard optimal currency area (OCA) factors, and the development of domestic financial sectors will attenuate this effect. Subsample analysis reveals that developed countries also face credit constraints in the global capital market and the negative effects of external liabilities on bilateral exchange rate risks are increasingly pronounced in countries facing more credit constraints.