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.
Key Findings
- For contracts initiated just before quarter-ends, banks with a one standard deviation larger ex-ante dollar funding gap pay on average a 118 basis points higher forward premium and obtain a 230 point higher contract value.
- Price gaps depend on relative capital positions in the cross section of banks—consistent with regulatory capital constraints being key drivers—and cannot be explained by differences in credit risk or supply factors.
- Moreover, the effects are concentrated in forward contracts with short maturities that are a cost-efficient way to hedge on-balance-sheet dollar exposure around regulatory key dates.
- The identified increase in short-term cross-quarter forward sales has nontrivial implications for banks’ total (net) dollar exposure, which drops about 20 percent for the average bank at the quarter-end relative to the first month in a quarter.
- These results suggest that demand drivers related to global banks currency imbalances are important drivers of deviations from covered interest parity.
Implications
The mechanisms that the authors identify are directly relevant to the current policy debate concerning global funding markets and the important role of the dollar in international finance and banking. First, the dominance of short-dated maturities, especially the one-week segment, in this important market reveals that global banks roll over their hedging and therefore engage in the inherent rollover risk while reducing their FX risk in this way. The significant value of on-balance-sheet currency imbalances of global banks, therefore, suggests non-negligible costs that could materialize under adverse market developments. Second, our findings suggest that banks have smaller currency imbalances (and thus larger funding gaps) at the end of the quarter compared with during the quarter. One key takeaway with regard to this finding is that supervisory point-in-time reporting policy (as opposed to an averaging scheme) of regulatory measures induces further price variation through banks that engage in window-dressing behavior. Moreover, this finding challenges the assumption made in some studies that banks do fully hedge any on-balance-sheet currency exposure using derivatives. Furthermore, the economically sizable differences in FX hedging costs across banks that the authors document likely have implications for the local and international efficacy of regulatory and monetary policy transmission.
Abstract
Using contract-level supervisory data, we show that dollar forward sales by non-US banks that are initiated at the end of a quarter and mature shortly after it concludes trade at higher prices and higher volumes. These effects are driven by banks with large net on-balance-sheet dollar assets that they can hedge around quarter-ends by selling dollars forward (increasing off-balance-sheet short positions), which suggests regulatory arbitrage to reduce capital charges for open foreign exchange (FX) exposure. Our results indicate that demand effects related to banks’ management of FX exposure are an important driver of deviations from covered interest rate parity.