Bank Foreign Currency Hedging and the Impact on Covered Interest Parity, an Emerging Market Perspective
50 Pages Posted: 1 Dec 2019
Date Written: October 30, 2019
This paper examines the role of banking sector foreign currency hedging demand in the foreign exchange market. First, the paper documents deviations from covered interest parity for a panel of emerging economies and tests whether resident bank foreign currency hedging needs affect these deviations. Next, I exploit data from Mexican regulatory filings on derivatives transactions and bank balance sheets to assess the impact of FX hedging demand from all resident banks, foreigners, and global banks operating in Mexico. These hedging demand measures are included in an econometric model of covered interest parity (under limits to arbitrage) with tenures from 1 month to 12 months, and then interacted with arbitrageur balance sheet constraint variables to test whether these amplify the impact of FX hedging demand. The main result of the paper is that bank hedging demand directly influences CIP deviations in the EM panel and the case of Mexico, while evidence of interaction effects is mixed. The direct effect of resident bank hedging demand is robust to including foreign exchange bid-ask spreads and arbitrage constraint variables in the regression model. In addition, global banks are the driver of this hedging effect. The results validate an important mechanism in the theoretical literature: that higher bank demand for foreign currency hedging, particularly from global banks, can directly increase the cost of hedging. This paper adds to the literature on CIP deviations by analyzing emerging market currencies, with the unique advantage of using regulatory data and observed FX derivatives transactions.
Keywords: foreign currency hedging, covered interest parity, global banking, financial stability, capital flows, currency mismatch, bank funding
JEL Classification: F3, G2, F65, G15, G18
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