The Pricing of FX Forward Contracts: Micro Evidence from Banks' Dollar Hedging
56 Pages Posted: 29 Oct 2018 Last revised: 21 Feb 2019
Date Written: 2018
Using transaction-level data on foreign exchange (FX) forward contracts, we document large demand-driven heterogeneity in banks' dollar hedging costs. For identification, we exploit regulatory end-of-quarter reporting that penalizes banks' currency exposure with capital surcharges. Contracts that reduce quarter-end currency exposure trade at higher prices, specifically for banks with high dollar funding gaps and high leverage, while access to internal dollar capital markets and bargaining power reduces prices. Spreads between similar contracts with and without initial margin widen with leverage. Our results suggest that banks' shadow costs of capital are important for the international propagation of shocks through FX derivatives markets.
Keywords: FX markets, hedging, price determination, global banks, international finance
JEL Classification: D40, E43, F30, F31, G15
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