Bank foreign currency funding and currency markets: the case of Mexico post GFC

Abstract

This paper examines the impact of foreign currency hedging demand on the foreign exchange market. First, the paper documents deviations from covered interest parity (CIP) for Mexico after the global financial crisis (GFC), and then it evaluates the effect of two variables in a regressionbased analysis: (i) the FX funding gap of domestic bank balance sheets and (ii) external foreign currency hedging demand. The main result is that both variables directly influenced CIP deviations in Mexico, and it was robust to including arbitrage funding and foreign exchange transaction costs in the regression. These results suggest hedging demand can be an important factor in emerging economies' foreign exchange forward markets, even at short maturities. One of the implications is that banks' ability to manage the currency mismatch is affected by global shocks in the foreign currency market.

Covered Interest Parity: A Stochastic Volatility Approach to Estimate the Neutral Band

“…With respect to deviations from CIP observed in Emerging Markets, Mexico in particular, on the one hand Carstens (1985) and Khor and Rojas-Suarez (1991) study dislocations between long-run equilibrium conditions and observed exchange rate in a peg exchange rate regime. Analysis of the post Global Financial Crisis in Hernandez (2014) and Bush (2019), on the other hand, suggests that liquidity constraints and risk are among the causes of observed deviations from CIP. These papers do not provide estimates of the neutral band for Mexico, however.…”