Working Paper

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.

Keywords: global imbalances; Exchange rate; Forward; Hedging; Covered interest rate parity; Currency options; COVID-19;

JEL Classification: E44; F31; F32; F41; G11; G15; G18; G20;

https://doi.org/10.17016/IFDP.2020.1283

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: International Finance Discussion Papers

Publication Date: 2020-05-28

Number: 1283