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.

Beyond Basis Basics: Liquidity Demand and Deviations from the Law of One Price

“…A previous version of this paper shows that deviations from covered interest rate parity in currency markets are related to hedging demand stemming from international capital flows. This relationship implies that deviations from covered interest rate parity contain information relevant for exchange rates, a point also made in Liao and Zhang (2020) and Greenwood et al. (2022), with the latter also connecting the results to global bond markets.…”

Beyond Basis Basics: Liquidity Demand and Deviations from the Law of One Price

“…A previous version of this paper shows that deviations from Covered Interest Rate parity in currency markets are related to hedging demand stemming from international capital flows. This relationship means that deviations from covered interest rate parity contain information relevant for exchange rates, a point also made in Liao and Zhang (2020) and Greenwood et al (2020), the latter also connecting the results with global bond markets. The supply and demand imbalance captured by bases also have implications for interpreting the interest rates embedded in derivatives prices (e.g., as studied by Binsbergen et al (2019)), which we discuss further in Internet Appendix A.7.…”

Cip Deviations, the Dollar, and Frictions in International Capital Markets

“…However, these non-U.S. institutional investors, such as pensions and insurance companies, typically have their liabilities in local currency. Therefore, they would need to fund their dollar purchases today and hedge the currency risk by selling dollars in the forward market, equivalent to borrowing dollars in the FX swap market Liao and Zhang (2020). andGreenwood, Hanson, Stein and Sunderam (2020) discuss the hedging demand channel in determining the spot exchange rate and CIP deviations.Systematic studies that disentangle FX hedged vs. unhedged flows into U.S. fixed income markets do not yet exist.…”