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Dealer Leverage and Exchange Rates: Heterogeneity Across Intermediaries

Author

Listed:
  • Ricardo Correa
  • Laurie Pounder Demarco

Abstract

In line with a growing literature on financial intermediary asset pricing, we find that changes in the leverage of primary dealers have predictive power in forecasting exchange rates. Unlike previous studies, we find that primary dealer heterogeneity matters for their role in asset pricing. The leverage of foreign-headquartered dealers in the United States entirely drive the predictive power on exchange rates, while the same measure for domestic U.S.-headquartered dealers is insignificant. The leverage of foreign-headquartered dealers also has more predictive power for some other assets. We argue that this heterogeneity is due to foreign broker-dealers having more balance sheet capacity relative to domestic dealers during the 2000s. This result conflicts with an assumption of homogeneity among intermediaries which is implicit in most modern intermediary asset pricing models. In addition, we find that currency market positions, including derivatives positions, are likely stronger than cross-border lending as the main channel through which leverage manifests itself in exchange rate changes.

Suggested Citation

  • Ricardo Correa & Laurie Pounder Demarco, 2019. "Dealer Leverage and Exchange Rates: Heterogeneity Across Intermediaries," International Finance Discussion Papers 1262, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgif:1262
    DOI: 10.17016/IFDP.2019.1262
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    File URL: https://www.federalreserve.gov/econres/ifdp/files/ifdp1262.pdf
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    References listed on IDEAS

    as
    1. He, Zhiguo & Kelly, Bryan & Manela, Asaf, 2017. "Intermediary asset pricing: New evidence from many asset classes," Journal of Financial Economics, Elsevier, vol. 126(1), pages 1-35.
    2. Cenedese, Gino & Della Corte, Pasquale & Wang, Tianyu, 2019. "Currency mispricing and dealer balance sheets," Bank of England working papers 779, Bank of England.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Exchange rates; Intermediaries; International finance; Leverage cycles; Primary dealers;

    JEL classification:

    • F30 - International Economics - - International Finance - - - General
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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