Global Dollar Exposure and Its Relationship with CIP Deviations

This paper analyzes a global map of dollar exposures and examines the relationship between net dollar exposures, defined as the difference between dollar assets and liabilities, and covered interest parity (CIP) deviations. We find that the cross-sectional relationship is significantly negative in advanced economies but positive in emerging markets. CIP deviations represent the hedging cost that foreign holders of dollar assets or liabilities incur to manage exchange rate risk. To explain, we develop a model in which the CIP deviations are determined by the demand and the supply side of hedging. The negative correlation in advanced economies can be explained by the variations in hedging demand. Larger net dollar exposures increase the hedging demand, raising hedging costs (reflected as more negative CIP deviations) and producing a negative correlation. In contrast, the positive correlation in emerging markets is explained by the supply side of the hedging market. Limited hedging supply leads to wider CIP deviations (more negative), encouraging firms to borrow in U.S. dollars rather than local currencies, thereby reducing net dollar exposures and generating a positive correlation.