The Hedging Channel of Exchange Rate Determination

Abstract

We document the exchange rate hedging channel that connects country-level measures of net external financial imbalances with exchange rates. In times of market distress, countries with large positive external imbalances (e.g. Japan) experience domestic currency appreciation, and crucially, forward exchange rates appreciate relatively more than the spot after adjusting for interest rate differentials. Countries with large negative foreign asset positions experience the opposite currency movements. We present a model demonstrating that exchange rate hedging coupled with intermediary constraints can explain these observed relationships between net external imbalances and spot and forward exchange rates. We find empirical support for this currency hedging channel of exchange rate determination in both the conditional and unconditional moments of exchange rates, option prices, large institutional investors' disclosure of hedging activities, and central bank swap line usage during the COVID-19 market turmoil.

Uncovering CIP Deviations in Emerging Markets: Distinctions, Determinants and Disconnect

“…Consistent with empirical literature documenting the role of global risk factors in driving CIP deviations in AEs (Du, Tepper and Verdelhan, 2018;Avdjiev, Du, Koch and Shin, 2019, among others), as well as recent theoretical advances on the macrofinancial channel of exchange rate determination (Gabaix and Maggiori, 2015;Liao and Zhang, 2020), we find evidence that global financial intermediaries' time-varying riskbearing capacity has a strong influence on the dynamics of EM CIP deviations based on offshore forward exchange rates. We first show that CIP deviations for Emerging European currencies with relatively integrated FX markets spike during quarter-ends and year-ends after 2016, when FX intermediation activities decline due to regulatory window-dressing of European banks and Global Systemically Important Banks (G-SIBs).…”

“…The costly financial intermediation theory yields a number of testable predictions in the EM context. Given that most major emerging market economies are net international debtors (excluding reserves), CIP deviations should respond to a tightening of intermediation capacity in the opposite way to that of net creditors, including most advanced economies (Liao and Zhang, 2020). We construct a measure of major foreign exchange dealer banks' leverage ratio in the spirit of He, Kelly and Manela (2017), and show that this measure is strongly correlated with EMs' off-shore CIP deviations.…”

Convenience yield and real exchange rate dynamics: A present‐value interpretation

“…We find that foreign exchange swap market frictions, which can also be interpreted as the deviation of covered interest parity (CIP) of the foreign exchange swap market, can significantly affect the real exchange rates for many countries. This result indicates that the deviations from CIP can affect the real exchange rate and resemble the importance of the failure in CIP empirically documented by Du, Tepper et al (2018) and Liao and Zhang (2021). Moreover, we find that in the euro area, Japan and Switzerland, when controlling for swap market frictions, the alternative convenience yields have different implications for real exchange rate movements from our baseline measure of convenience yields.…”

“…They find that, even many years after the global financial crisis, the need for liquidity has fallen and the deviations from CIP remain. Liao and Zhang (2021) also use a theoretical model with a currency hedging channel to explain the fact that, during the times when market volatility is high, countries with large positive external imbalances experience home currency appreciation, and the forward exchange rate relatively appreciates more than the spot exchange rate after adjusting for interest rate differentials; thus, it creates the deviations from CIP. Du, Tepper et al (2018) argue that financial institutions are not undertaking the arbitrage that would result in profits.…”

The Global Dollar Cycle

“…The U.S. dollar basis has generally been negative for the Australian and New Zealand dollars, for reasons elucidated byBorio and others (2016) andLiao and Zhang (2020). For a broad discussion of the literature on deviations from CIP, seeDu and Schreger (2022).…”