Preference reversal and quantitative easing

Abstract This study examines how U.S. quantitative easing (QE) has influenced risk‐taking in foreign exchange markets, focusing on the unintended spillover effects of the U.S. central bank's efforts to prop up market risk‐taking in major and emerging market currencies outside the U.S. economy. Using a polynomial utility framework, we demonstrate that QE has enticed asymmetric, tail‐risk‐seeking behaviors, especially in currencies without direct central bank intervention, such as the Mexican Peso. While inflation would typically discourage foreign speculation under purchasing power parity (PPP), QE's indirect effects on these non‐QE currencies amplify speculative interest. This preference reversal is most pronounced in the Americas (the Canadian Dollar and the Mexican Peso) and select European currencies (the Norwegian Krone), contrasting with more subdued effects in mainland European markets. Our findings reveal that inflation in Mexico, absent domestic intervention, has fueled a type of risk‐seeking behavior whose bond market‐propping effects the U.S. policy‐makers likely intended to contain domestically. This study addresses the “leakage” of QE benefits and risks across borders, providing evidence that QE has led to credit expansion and heightened tail‐risk‐taking in non‐QE economies. The study also examines a global equilibrium framework to assess how QE impacts cross‐currency financial variables, highlighting disparities in iso‐risk adjustments. This research highlights the global impact of unconventional monetary policy, suggesting that U.S. QE inadvertently promotes speculative activity and reshapes risk preferences in economies beyond its target domicile, challenging traditional efficiency assumptions in international markets.