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Dealer Risk Limits and Currency Returns

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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.

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  • Omar Barbiero & Falk Bräuning & Gustavo Joaquim & Hillary Stein, 2024. "Dealer Risk Limits and Currency Returns," Working Papers 24-11, Federal Reserve Bank of Boston.
    • Handle: RePEc:fip:fedbwp:98847
    DOI: 10.29412/res.wp.2024.11
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    References listed on IDEAS

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    1. Hong, Harrison & Yogo, Motohiro, 2012. "What does futures market interest tell us about the macroeconomy and asset prices?," Journal of Financial Economics, Elsevier, vol. 105(3), pages 473-490.
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    Cited by:

    1. de Boer, Jantke & Eichler, Stefan, 2024. "FX dealer constraints and external imbalances," Ruhr Economic Papers 1132, RWI - Leibniz-Institut für Wirtschaftsforschung, Ruhr-University Bochum, TU Dortmund University, University of Duisburg-Essen.

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    More about this item

    Keywords

    exchange rates; currency returns; market making; risk constraints; financial intermediation;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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