The Hedging Channel of Exchange Rate Determination

67 Pages Posted: 15 Jun 2020

See all articles by Gordon Liao

Gordon Liao

Board of Governors of the Federal Reserve System

Tony Zhang

Board of Governors of the Federal Reserve System

Date Written: May, 2020

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.

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

Suggested Citation

Liao, Gordon and Zhang, Tony, The Hedging Channel of Exchange Rate Determination (May, 2020). FRB International Finance Discussion Paper No. 1283, Available at SSRN: https://ssrn.com/abstract=3625103 or http://dx.doi.org/10.17016/IFDP.2020.1283

Gordon Liao (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Tony Zhang

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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