Dealer Risk Limits and Currency Returns

50 Pages Posted: 13 Mar 2024

See all articles by Omar Barbiero

Omar Barbiero

Federal Reserve Banks - Federal Reserve Bank of Boston

Falk Bräuning

Federal Reserve Banks - Federal Reserve Bank of Boston

Gustavo Joaquim

Federal Reserve Bank of Boston

Hillary Stein

Federal Reserve Banks - Federal Reserve Bank of Boston

Date Written: February 15, 2024

Abstract

We leverage supervisory micro data to uncover the role of global banks' risk limits in driving exchange rate dynamics. Consistent with a model of currency intermediation under risk constraints, shocks to dealers' risk limits lead to price and quantity adjustment in the foreign exchange market. We show that dealers adjust their net exposure and increase spread in response to granularly identified limit shocks, leading to lower turnover and an adjustment in currency returns. These shocks exacerbate effects of net currency demand on exchange rate movements, as predicted by theory, and trigger deviations from covered and uncovered interest parity.

Keywords: exchange rates, currency returns, market making, risk constraints, financial intermediation

JEL Classification: F31, G15, G21

Suggested Citation

Barbiero, Omar and Bräuning, Falk and Joaquim, Gustavo and Stein, Hillary, Dealer Risk Limits and Currency Returns (February 15, 2024). Available at SSRN: https://ssrn.com/abstract=4728116 or http://dx.doi.org/10.2139/ssrn.4728116

Omar Barbiero

Federal Reserve Banks - Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

Falk Bräuning (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

Gustavo Joaquim

Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

Hillary Stein

Federal Reserve Banks - Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

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