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External imbalances and FX returns

Hedge ratios of international investment positions have increased over past decades, spurred by regulation and expanding derivative markets. This has given rise to predictable movements in spot and forward exchange rates. First, on balance hedgers are long currencies with positive net international investment positions and short those with negative international investment positions. With intermediaries requiring some profit for balance sheet usage these trades command negative premia and widen cross-currency bases. Second, hedge ratios increase in times of rising FX volatility. An increase in the hedge ratio for a currency puts downward pressure on its market price in proportion to its external imbalance and bodes for higher medium-term returns. Also, the dispersion of cross-currency bases increases in times of turmoil.

Liao, Gordon and Tony Zhang (2020), “The Hedging Channel of Exchange Rate Determination”, International Finance Discussion Papers 1283.

The below are quotes from the paper. Cursive text and text in brackets have been added for clarity.
The post ties up with this site’s summary on systematic value generation through macro trends.

Hedging and exchange rates

“Variation in investors’ and borrowers’ desires to hedge exchange rate risks in their net foreign asset positions, along with intermediary frictions, explain a number of stylized facts in international financial markets…Hedging behavior generates predictable movements in both spot and forward exchange rate markets that are also intimately linked to countries’ external balances.”

“The exchange rate hedging channel…connects country-level measures of net external financial imbalances with exchange rates. In times of market distress, countries with large positive external imbalances experience domestic currency appreciation, and crucially, forward exchange rates appreciate relatively more than the spot after adjusting for interest rate differentials. Countries with large negative foreign asset positions experience the opposite currency movements…Exchange rate hedging coupled with intermediary constraints can explain these observed relationships between net external imbalances and spot and forward exchange rates.”

“The hedging-driven demand for currencies during times of financial distress generates persistent differences in the returns to investing in different currencies. Currencies that appreciate in bad times earn a lower risk premium, as they provide a hedge against economic downturns.”

The rise of FX hedging

“Investment regulations and guidances for institutional investors, as well as optimization around the hedging of currency volatility contributed to a general increase in hedge ratios.”

Many countries have regulations that restrict currency mismatch and encourage currency hedging for foreign assets. Additionally, the use of derivative instruments for currency hedging is often explicitly excluded from counting toward limits on derivative use. Post-global financial crisis rules for insurers, such as the Solvency II Directive, have also contributed to increased currency hedging. Furthermore, large corporate debt issuers in developed countries have been increasingly engaged in currency-hedged foreign debt issuance in order to obtain cheaper borrowing costs.”

“Foreign institutional investors have in recent years hedged a large fraction of the currency exposure on their foreign asset holdings through forwards and swaps. Their hedging behavior is time varying, and, moreover, their hedge ratio typically increases with currency volatility.”

“[The figure below] shows the hedge ratio of nine large Japanese life insurers on their foreign asset holdings against the Currency Volatility Index (CVIX)—a measure of implied exchange rate volatility analogous to the VIX Index.”

“Institutional investors and borrowers hedge a sizable portion of their currency mismatches. This set of participants has a particularly strong presence in the bond market…with…an increasing trend of currency-hedged corporate bond issuance…The high hedging ratio for debt is unsurprising since exchange rate risk is large relative to fixed income returns but small relative to equity returns and the risk-minimizing currency strategy for a global bond investor is close to a full currency hedge… Motivated by this evidence, we employ measures of external imbalance that excludes equity portfolio holdings [when looking at the relation between imbalances and hedging demand].”

The importance of international investment positions

“In countries with large positive external imbalances, as captured by their Net International Investment Positions (NIIP) and particularly their net debt and foreign direct investment (FDI) positions, the forward prices of domestic currency versus the U.S. dollar are unconditionally elevated relative to the spot price after adjusting for the interest rate differentials. This relative valuation between the forward and spot prices results in a currency basis, also known as a deviation from covered interest rate parity. In contrast, countries with large negative external imbalances generally observe an unconditional forward price of domestic currency that is depressed relative to the U.S. dollar.”

The cross-currency basis is the amount by the cost of direct borrowing in foreign currency exceeds that of borrowing locally and swapping it into foreign currency versus the FX derivatives market. A negative USD basis, for example, means that it is cheaper to borrow directly in the USD market. The cross-currency basis marks a deviation from the covered interest parity paradigm. For a full explanation view post here.

In periods of increased market volatility, countries with positive external imbalances experience domestic currency appreciation in both spot and forward exchange rate markets whereas countries with negative external imbalances experience currency depreciation. Moreover, forward exchange rates experience a greater magnitude of price movements relative to spot exchange rates after adjusting for interest rate differentials. This difference in exchange rate adjustment between the forward and the spot markets results in the increased cross-sectional dispersion of currency bases in line with the direction and magnitude of external imbalances.”

An increase in a foreign country’s hedge ratio impacts the country’s spot exchange rate in proportion to its external imbalance… In times of financial distress, investors increase their hedge ratio in response to increased exchange rate volatility. Swap traders use dollars to purchase additional units of foreign currency to satisfy the additional demand in forward markets from countries with positive external imbalances. As a result, countries with large positive external imbalances experience domestic currency appreciation. By similar logic, countries with large negative foreign asset positions experience domestic currency depreciation… The magnitude of the effect of swap trader activity on spot exchange rate markets is directly proportional to the relative magnitude between the demand for dollars originating from hedging demand, and the demand for dollars from other sectors of the economy.”

On evidence for the link between FX swap market imbalances and breakdowns in covered interest parity view post here.

The importance of market frictions

“If the agent is a net purchaser of foreign assets, then she hedges her exchange rate risk by selling dollars in the forward market. On the other hand, a net borrower hedges exchange rate risk by buying dollars forward. Hence, the quantity of dollar forwards demanded depends on the country’s hedge ratio and net foreign asset position.”

To satisfy investors’ hedging demands, financial intermediaries produce forwards by trading the spot exchange rate along with the two countries’ interest rates. Take for example Japan, which has substantial investor holdings of dollar assets and a positive foreign asset position. The representative Japanese investor hedges her exchange rate exposure by selling dollars and buying yen in the forward market with a financial intermediary. Hence, the financial intermediary must supply yen in the forward market.”

“However, the intermediary has alternative competing investment opportunities and therefore charges a spread for providing liquidity in the forward market. In our example, the forward price of the yen is elevated relative to spot exchange rate even after adjusting for interest rate differentials. The resulting spread is known as the cross-currency basis: the difference between the FX-implied yen interest rate and the actual yen interest rate.”

“Moreover, the magnitude of the difference between spot and forward exchange rates [increases] with the quantity of forwards that must be supplied, because the intermediary must be induced to devote more of her limited capital towards providing liquidity. In times of economic distress, investor hedging demand combined with constrained financial intermediation generate predictable changes in forward and spot exchange rates. This occurs due to two factors. First, a rise in a country’s hedge ratio increases the magnitude of the investor’s demand for forwards in proportion to the country’s net foreign asset position. Second, a rise in the constraints to financial intermediation leads to increases in the absolute level of bases required to induce intermediaries to provide liquidity. However, countries that are net savers should observe a currency basis in the opposite direction of countries that are net borrowers as their hedging demand differs in direction.”

“In addition to affecting the forward exchange rates, investor demand for forwards can spillover to the spot exchange rate market. Intermediaries that supply yen forward must buy yen in the spot market. As such, hedging pressure in the forward market imparts price pressure on spot exchange rates. In periods of market distress when the demand for either entering new hedges or rolling existing maturing hedges are large, hedging demand can drive the dynamics of both spot and forward exchange rate markets in predictable directions linked to countries’ net external imbalancesspot exchange rate appreciates (depreciates) for countries with net positive (negative) external imbalance.”

The empirical evidence

“We find empirical support for this currency hedging channel of exchange rate determination in both the conditional and unconditional moments of exchange rates.”

“Taking the model predictions to the data, we show support for the hedging channel of exchange rate determination in the behavior of both forward and spot exchange rates. In addition to the stylized facts…we draw on event studies of three crises — the COVID-19 Pandemic, the Eurozone crisis in 2011, and the Global Financial Crisis — and show that movements in forward and spot exchange rates are all consistent with increases in hedging demand during periods of financial distress.”

“Furthermore, we present evidence in the pricing of currency options that also points to the presence of the hedging demand consistent with our observations on forward exchange rates. Countries with positive external imbalances can also hedge against domestic currency appreciation by buying call options on domestic currency. As a result, we find that out-oft-the- money call options on currencies with positive (negative) external imbalance generally have a premium (discount) over out-of-the-money puts. The relative pricing of puts and calls also varies across time, similar to currency basis spreads.”

“We construct a risk-factor to proxy for changes in countries’ hedging demands and the availability of financial intermediation: changes in the mean absolute magnitude of the cross-currency bases. We find that both spot and forward exchange rate returns load on this risk-factor consistent with measures of external imbalances. Additionally, our single-factor model explains a significant amount of variation in spot and forward returns as well as option skews over time.”


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