The Hedging Channel of Exchange Rate Determination

Gordon Liao and Tony Zhang
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Tony Zhang: https://www.federalreserve.gov/econres/tony-zhang.htm

No 1283, International Finance Discussion Papers from Board of Governors of the Federal Reserve System (U.S.)

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.

Keywords: global imbalances; Exchange rate; Forward; Hedging; Covered interest rate parity; Currency options; COVID-19 (search for similar items in EconPapers)
JEL-codes: E44 F31 F32 F41 G11 G15 G18 G20 (search for similar items in EconPapers)
Pages: 67
Date: 2020-05-28
New Economics Papers: this item is included in nep-mac, nep-mon and nep-opm
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Citations: View citations in EconPapers (15)

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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgif:1283

DOI: 10.17016/IFDP.2020.1283

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