Dealer Risk Limits and Currency Returns 
Empirical validation of the theory that financial frictions such as financial institutions’ risk-bearing constraints can affect exchange rate dynamics has eluded researchers in part because it is difficult to observe the constraints of the specific actors. The fact that risk-bearing constraints are endogenous to the broader market conditions that may govern exchange rates further hinders validation. This paper provides empirical support for the role of financial intermediaries in driving exchange rate dynamics by focusing on the constraints of global banks’ currency trading desks. The authors use a novel supervisory data set on risk limits at the trading-desk level to show that movements in market-maker constraints do in fact affect exchange rates when there is a currency flow to be mediated.
Key Findings
- Shocks to banks’ risk limits have sizable effects on exchange rates, exacerbating the effects from shifts in net currency demand.
- Tighter risk-limit shocks prompt larger bid–ask spreads and a reduction in aggregate exposure of US dealers toward foreign currencies, regardless of the direction of currency flows.
- The effects of idiosyncratic limit shocks on foreign exchange markets are transitory, suggesting that other dealer banks step in over time and bring the exchange market back to the previous equilibrium.
- Risk-limit shocks also cause changes in covered interest parity deviations, which serves as evidence that banks’ intermediation ability is a key mechanism behind the findings. Consistent with the finding that bid–ask spreads increase at the currency level, intermediation spreads (trading margins) across all currencies at the bank level also increase.
- For the majority of currencies, risk-limit shocks have significant and sizable effects, although there is variation in the magnitude of the exchange rate response, with more volatile currencies exhibiting stronger responses to such shocks.
Implications
Market makers may hold only a small share of the total foreign exchange risk, yet due to their central intermediation function, shocks to their risk limits have sizable implications for currency pricing.
Abstract
We leverage supervisory microdata 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 adjustments in the foreign exchange market. We show that dealers adjust their net position and increase the bid–ask spread in response to granularly identified limit shocks, leading to lower turnover and an adjustment in currency returns. These shocks exacerbate the effects of net currency demand on exchange rate movements, as predicted by theory, and trigger deviations from covered interest parity.