Demand Effects in the FX Forward Market: Micro Evidence from Banks’ Dollar Hedging
Aggregate data suggest that all major banking sectors outside the United States have sizable dollar funding gaps; that is, a large percentage of their on-balance-sheet dollar assets is not funded with on-balance-sheet dollar liabilities. Banks can hedge the resulting foreign exchange (FX) risk with a forward dollar sale, and 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 demand-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 and capital around quarter-ends, when regulatory risk-weighted capital constraints become binding.
This is a substantially revised version of the original paper, titled “The Pricing of FX Forward Contracts: Micro Evidence from Banks’ Dollar Hedging” and posted in November 2018.