Hedging Demand Amplifies Currency Movements

Research by economists Bräuer and Hau has found that currency hedging plays a significant role in exchange rate movements. They analyzed daily data from CLS, the world's largest multi-currency cash settlement system, covering seven major dollar pairs: EUR/USD, GBP/USD, USD/JPY, USD/CHF, USD/CAD, AUD/USD, and NZD/USD.

The study shows that a large part of cross-border bond investment is hedged in derivatives. When foreign investors buy US dollar-denominated bonds, they often hedge their position by selling dollars forward and buying euros forward. Primary dealer banks take the other side of this contract and offset their exposure through covered interest parity arbitrage.

This 'hedging channel' works alongside the familiar capital-flow channel. The initial purchase of a US bond creates spot demand for dollars, while the hedge partly reverses that demand. When the bond position is fully hedged, only the unhedged component of the capital inflow supports the dollar.

The study estimates that changes in hedging positions have more explanatory power than changes in bilateral bond holdings themselves. The researchers found a strong negative relationship between hedging pressure and the US dollar's spot rate, with a correlation of -0.70. A one-standard-deviation increase in hedging pressure is associated with a 0.72% dollar depreciation.

The study also examines the response of funds to changes in the dollar price. The researchers find that funds hedge less after the dollar strengthens, reducing demand for net dollar-short positions by about 0.19%. This negative response of hedging demand to the dollar creates a reinforcing feedback loop, amplifying currency movements.