The Pricing of FX Forward Contracts: Micro Evidence from Banks’ Dollar Hedging
Global banks tend to borrow funds in the local currency, convert them into dollars, and hedge the resulting foreign exchange (FX) risk with a forward dollar sale. The cost of this dollar hedging crucially affects banks’ portfolio allocation and has important implications for the transmission of shocks to the wider economy. The authors use novel contract-level data on German banks’ USD/EUR forward contracts to study this cost and argue that funding-related factors are key drivers in currency markets, in particular, in the forward market. Specifically, they look at how dollar hedging costs depend on banks’ dollar funding gap, dollar funding composition, access to internal capital markets, and capital.