During the market turbulence brought about by Covid-19 in March 2020, exchange rate volatility increased substantially. The Broad Dollar Index rose as much as 8% in a two week span at its peak. Foreign institutions borrowed close to half a trillion dollars, using the Federal Reserve’s dollar liquidity swap line which helped ease dollar liquidity (Cetorelli et al. 2020, Bahaj and Reis 2020).
Yet the dollar’s relative strength against other currencies during this episode of market distress was not uniform. The currencies of net investor countries, such as the Japanese yen and the euro, appreciated against the dollar in both forward and spot exchange rate markets. In contrast, the currencies of net debtor countries depreciated. Moreover, net investor countries demonstrated a greater need for dollar funding and drew more on their Federal Reserve swap lines. Net debtor countries, perhaps surprisingly, tended not to use their swap lines. How can we account for these differences in exchange rate market behaviour across countries?
In a recent paper (Liao and Zhang 2020), we propose that investors’ desire to hedge exchange rate risk in their net foreign asset positions explains the movements in exchange rates and swap line usage discussed above (as well as a number of other stylised facts in international finance). Crucially, this hedging channel of exchange rate determination connects exchange rate behaviour to countries’ external imbalances through the behaviour of financial intermediaries.
The hedging channel of exchange rate determination
We start by providing a framework to analyse hedging demand and its impact on exchange rate markets. Consider a Japanese investor holding a net positive balance of US dollar denominated assets. This Japanese investor hedges a share of her net foreign asset position with forward (or swap) contracts to stabilise the future payoff of her portfolio in her domestic currency (the yen). To perform this transaction, the Japanese investor sells dollars and buys yen in the forward currency market from some financial intermediary.
Financial intermediaries synthetically produce1 forward contracts and charge a spread for providing liquidity, which reflects their balance sheet costs. This spread is commonly known as the ‘cross-currency basis’ or ‘deviation from covered interest rate parity’.2 The magnitude and direction of the currency basis depend on the external imbalance and the hedging ratio. Since the Japanese investor ‘demands yen forwards’, the forward yen exchange rate is overvalued relative to its spot exchange rate (after adjusting for interest rate differentials).
On the other hand, debtor countries, such as New Zealand, hold a net negative balance of US dollar-denominated assets, hedging their exchange rate risk by buying dollars and selling domestic currency in the forward market. As a result, a debtor country’s forward exchange rate is undervalued relative to its spot exchange rate.
In times of financial distress, hedging demand increases and financial intermediary constraints tighten, generating predictable movements in forward and spot exchange rates. Notably, institutional investors typically increase their hedge ratios in the face of increased exchange rate volatility. This increases their demand for forward options in proportion to their external imbalances. For example, Figure 1 shows the hedging ratio of Japanese life insurers, which systematically rises and falls with market-implied currency volatility.
Figure 1 Currency hedge ratio and currency volatility
Note: The hedge ratio is calculated by dividing the net notional amount of foreign currency forward and swap contracts (sold minus bought) by the foreign currency-denominated asset holdings reported in public disclosures of nine large Japanese insurers.
As a result of increased hedging demand along with tightening intermediary constraints, countries with net positive external imbalances observe their forward exchange rates appreciate, leading to both greater overvaluation of their forward exchange rate, as well as upwards price pressure onto their spot exchange rate through intermediary trading. Countries with net negative external imbalances exhibit the opposite movements in forward and spot exchange rates. Figure 2 shows the dynamics of forward and spot exchange rates of G10 currencies during the Covid-19 pandemic. The trends directly support the predictions of our framework. Panel A shows that the forward exchange rates of countries with positive external imbalances became more overvalued during the Covid-19 market distress. Panel B shows that the spot exchange rate associated with these countries also appreciated during this time.
Figure 2 Changes in FX rates during the Covid-19 market distress
Note: This figure plots changes in the 1-year cross-currency bases and spot exchange rates during the COVID-19 crisis. We measure changes in currency bases and exchange rates from February 1, 2020 to March 13, 2020, the Friday before the Federal Reserve cut the federal funds rate by 100 basis points and extended central bank swap line provision on Sunday March 15, 2020. The Norwegian Krone is omitted when calculating the correlation and the regression line between log spot exchange rate returns and external imbalances due to its reliance on oil prices. See Liao and Zhang (2020) for further discussion.
In addition to the analysis of exchange rates during the Covid-19 pandemic, our research shows similar exchange rate dynamics during the 2008 global crisis, as well as during the 2011 eurozone crisis. Moreover, this systematic variation in hedging demand and intermediary constraints (as captured by the magnitude of cross-currency bases) explain a sizeable portion of the dynamics of G10 currencies from since the global crisis. As a result, the relationship between hedging demand, external imbalances, and exchange rate dynamics helps resolve the perennial puzzle that exchange rates appear disconnected from macroeconomic fundamentals. Even though country-level external imbalances tend to be persistent, time-varying hedging ratios that ‘co-vary’ systematically over the business cycle provide the quantity shifts that accord with the exchange rate movements.
Moreover, these exchange rate movements observed during times of financial distress constitute a currency crash risk that demand compensation in normal times. Currencies of countries with negative external imbalances that depreciate in times of heightened market volatility (e.g. the New Zealand dollar) demand higher excess returns. Currencies of countries with positive external imbalances appreciate during market distress (e.g. the yen) and obtain lower excess returns in normal times. Thus, our hedging channel provides an explanation for the link between currency excess returns and external imbalances (Della Corte 2016).
Foreign exchange option prices provide another piece of evidence for the currency hedging channel. Investors in currency areas with positive external imbalances purchase ‘calls’ on the domestic currency as a hedge to keep the home currency payout of investments stable. Hence, the relative prices of ‘calls’ on yen are higher than the prices of ‘puts’ on the yen (when measured as option risk-reversals).3 Currency areas with negative external imbalances demand ‘puts’ on domestic currency. As a result, the relative prices of their puts are higher than the prices of their calls. We find evidence for both of these predictions in the data. Hence, the option market provides another important signpost, along with the forward valuation, in showcasing the impact of currency hedging demand on external imbalance.
Central bank swap line usage
The currency hedging channel also delivers insights into the usage of central bank swap lines. The draws on the swap lines across currencies during the recent Covid-19 episode align with the hedging of external imbalances (as shown in Figure 3). Continuing with Japan as an example, the increased institutional hedging demand for yen forward options can be alleviated by the dollar swap line, because the swap line provides dollars in the spot market today in exchange for dollars in the forward market at the maturity date. Japanese financial intermediaries that supply yen forwards can draw on the dollar swap line as a source of funding for dollar loans necessary in the production of forward contracts.
In the cross section, even though debtor countries are generally more in need of dollars, it is the countries with positive external imbalance that draw on the swap line the most. This behaviour can be explained in part by our hedging channel in addition to the funding needed for dollar liquidity by the banking sector (Goldberg et al. 2010). However, the increased demand for longer maturity swap line operations (three months this time around, as opposed to the seven-day operations) points to our hedging channel. As short-term foreign exchange swaps are substitutable with domestic ‘repo funding’ (Correa et al. 2020), a lower fraction of short-term swap line draws (relative to the total swap line usage) suggests that swap lines are being used less for funding and more for hedging purposes. At the time of the max swap line draw during the Covid-19 market distress, the fraction of short-term swap usage was less than 3% of the total, whereas it was more than 40% during the worst days of the global crisis.
Figure 3 Central bank swap line usage during Covid-19
Notes: This figure plots maximum swap line draws by central banks during the Covid-19 market turmoil against measures of external imbalances taken from the latest quarterly data available in 2019. Panel A plots the maximum swap line draws for the currency regions with permanent swap lines with the Federal Reserve. Panel B plots the maximum swap line draws for the currency regions with temporary swap lines with the Federal Reserve that were established during the Covid-19 crisis.
Ultimately, we believe our research makes three main contributions towards understanding the role of financial institutions in determining exchange rate behaviour. First, while much of the recent research highlights the supply of intermediation services in determining exchange rates, we show how a better understanding of the demand for intermediation services allows us to explain the differences in exchange rate behaviour across countries. Second, our research helps explain the use of central bank swap lines during the most recent Covid-19 financial turmoil and provides potential guidance for future policy actions. Finally, the hedging channel of exchange rate determination connects the behaviour of forward and spot exchange rates to countries’ external imbalances. As a result, the hedging channel may be able to address the ‘reconnect’ between exchange rates and macroeconomic fundamentals in recent years (Lilley et al. 2020).
Bahaj, S and R Reis (2020), "Central bank swap lines during the Covid-19 pandemic", Covid Economics 2.
Cetorelli, N, L Goldberg and F Ravazzolo (2020), "Have the Fed Swap Lines Reduced Dollar Funding Strains during the COVID-19 Outbreak?", Liberty Street Economics.
Correa, R, W Du and G Liao (2020), "U.S. Banks and Global Liquidity", NBER Working Paper.
Della Corte, P, S Riddiough and L Sarno (2016), "Currency Premia and Global Imbalances", Review of Financial Studies 29 (8): 2161–2193.
Du, W, A Tepper and A Verdelhan (2018), "Deviations from Covered Interest Rate Parity", Journal of Finance 73(3): 915-957.
Goldberg, L S, C Kennedy and J Miu (2010), "Central Bank Dollar Swap Lines and Overseas Dollar Funding Costs", NBER Working Paper.
Liao, G and T Zhang (2020), "The Hedging Channel of Exchange Rate Determination", International Finance Discussion Paper.
Lilley, A, M Maggiori, B Neiman and J Schreger (2020), "Exchange Rate Reconnect", VoxEU.org, 24 January.
1 To produce yen forwards, an intermediary borrows in dollars, converts the borrowed dollars to yen, which will earn the yen interest rate. At maturity, the intermediary delivers yen into the forward contract in exchange for dollar. Then, the intermediary repays her dollar loan.
2 A deviation from covered interest rate parity (CIP) arises when the forward exchange rate differs from the spot exchange rate after adjusting for the interest rate differentials. CIP deviation is often measured by the cross-currency basis swap spread that reflects the difference between FX-implied cash funding rate and the actual cash funding rate. See Du et al. (2018) for a discussion of CIP deviations with emphasis on supply-side constraints.
3 Option risk reversals are a measure of the relative pricing of calls and puts for a given currency, and it is defined as the implied volatility of the out-of-the-money call minus that of the put.
4 Financial intermediaries can exchange the borrowed dollar for yen today and hold the yen exposure to deliver into the forward contract at the agreed upon maturity. This procedure also involves the intermediary purchasing yen in the spot market, contributing to the appreciation of yen spot exchange rate
5 Maximum swap line draws during the Covid-19 financial turmoil was $449 billion on May 27, 2020 ($436 billion are of the 84-day operation and $13.3 billion are of the 7-day operation). The max swap line draw during the Global Crisis was $586 billion on 4 December 2008 ($345 billion were of operations with maturities greater than 30 days and $241 billion were of maturities less than 30 days).