Currency Mispricing and Dealer Balance Sheets
63 Pages Posted: 12 Feb 2019
Date Written: January 31, 2019
We relate currency mispricing originating from the breakdown of covered interest rate parity to the dealer balance-sheet constraints resulting from the post-crisis financial regulation. Using a unique dataset on contract-level foreign exchange derivatives with disclosed counterparty identities, we find that dealers with a higher leverage ratio demand an additional premium from their clients for synthetic dollar funding. We handle endogeneity using two exogenous variations associated with the public disclosure of the leverage ratio, and the introduction of the UK leverage ratio framework while controlling for changes in demand conditions at the client level.
Keywords: Exchange rates, dollar basis covered interest parity condition, arbitrage opportunities
JEL Classification: F31, G12, G15
Suggested Citation: Suggested Citation