The Hedging Channel of Exchange Rate Determination

Abstract

We document the exchange rate hedging channel that connects country-level measures of net external financial imbalances with exchange rates. In times of market distress, investors increase their currency hedging activities in proportion to their overall net foreign asset exposure by purchasing forward contracts. Countries with large positive external imbalances (e.g. Japan) 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. We present a model demonstrating that exchange rate hedging coupled with intermediary constraints can explain these observed relationships between net external imbalances and spot and forward exchange rates. We find empirical support for this currency hedging channel of exchange rate determination in both the conditional and unconditional moments of exchange rates, option prices, and large institutional investors’ disclosure of hedging activities. The currency hedging channel also explains the observed cross-sectional heterogeneity in the usage of the Federal Reserve dollar liquidity swap lines during the COVID-19 financial turmoil.