Risk, Specialization, and Covered‐Interest Parity

Abstract

Prevailing theories of financial intermediation assume an integrated financial sector with frictionless risk‐sharing. However, we identify substantial risk‐sharing frictions linked to intermediary specialization using currency derivatives markets as a laboratory. Using confidential supervisory data covering $25 trillion in daily bank exposures, we document imperfect hedging in banks' FX‐swap intermediation: banks rarely hedge their synthetic dollar lending with maturity‐matched foreign safe assets. Intermediaries specialize in markets in which they have expertise in managing the associated exposures, giving rise to cross‐market variation in deviations from covered‐interest parity. Our results highlight the importance of intermediary specialization and its impact on risk premia.