UC Berkeley

Since the beginning of my graduate studies at Berkeley, I have had a deep interest in foreign exchange. This is naturally at the heart of international finance, however recently a surge of research papers have been investigating not the market for spot contracts, which is conventionally what most people refer to when talking about foreign exchange, but rather derivative markets, including forwards and forex swaps. This transition in interest has largely occurred because of recent post-crisis developments in forex swap markets. Since 2008, we have witnessed persistent deviations of covered interest rate parity. This is an arbitrage condition, and states that the costs of borrowing local and foreign currency should be equal after eliminating exchange rate risk using a forward contract. The focus of the first chapter of my thesis is largely to propose an explanation to explain the violation of this arbitrage condition,

In the first chapter, I interpret the puzzle as a persistent dollar financing premium for banks in the Euro area, Japan and Switzerland. While prior literature has typically focused on explaining the dollar borrowing premium as stemming from limits to arbitrage and the supply of dollars in the forex swaps, I provide an alternative explanation, that is centered on unconventional monetary policies of the European Central Bank, Bank of Japan and Swiss National Bank. Using a model of the foreign exchange swap market, I explore two channels through which the unconventional monetary policies, namely Quantitative Easing (QE) and negative interest rates, can create an excess demand for dollar funding. In the first, QE leads to a relative decline in domestic funding costs, making it cheaper for international banks to source dollars via forex swaps, relative to direct dollar borrowing. In the second, negative interest rates cause a decline in domestic interest rate margins, as loan rates fall and deposit rates are bound at zero. This induces banks to rebalance their portfolio toward dollar assets, again creating a demand for dollars via forex swaps. Both policies thus lead to an increase in the excess demand for dollars in the forex swap market. To absorb the excess demand, financially constrained dealers increase the premium that banks must pay to swap domestic currency into dollars. To support model predictions, I show empirically that CIP deviations have tended to widen around negative rate announcements. I also document a rising share of dollar funding via the forex swap market for U.S. subsidiaries of Eurozone, Japanese and Swiss banks in response to a decline in domestic credit spreads.

In the second chapter (coauthored with Olav Syrstad), we investigate in more detail price-setting in the forex swap market. Given the pricing of forwards no longer obeys the iron law of covered interest rate parity, this paper examines the information content of order flow. Order flow is measured as the net of buyer initiated transactions in the forex swap interdealer market, and can be used by dealers as a measure of underlying imbalances in forex swaps. This is important for price-setting as dealers typically keep flat positions on a day-to-day basis. An unexpected rise in order flow therefore cause the interdealer market to reset prices to restore order flow, resulting in an increase in the forward premium customers pay to swap into dollars, widening CIP deviations.

We provide evidence that an unconditional shock to order flow causes a widening of CIP deviations. We then test two sources of shocks to customer demands for forex swaps. First, we test whether there is an increase in order flow around expansionary unconventional monetary announcements. We find limited evidence that a rise in order flow following expansionary monetary announcements, supporting the contemporaneous price-setting. In contrast, we find evidence in support of price-setting via order flow when examining Federal Reserve Swap line allotments during 2008-2010. This caused a decline in order flow and a narrowing of the cross-currency basis. The results are consistent in a framework in which monetary surprises represent publicly available information that is wholly contained in the dealer information set. Swap line allotments are made to a subset of banks, and so act as \text{italic}{idiosyncratic} shocks to order flow that are unanticipated by dealers result in price-setting following a rise in order flow. Finally, we show that dealer leverage matters: around quarter-ends, there is evidence that order flow of short-term swaps rises, leading to a widening of cross-currency basis. This is due to dealers offloading holdings of short-term swaps in order to meet regulations on leverage.

In the third chapter (coauthored with Christian Jauregui), I examine the international effects of monetary policy. Much has been written on the domestic effects of the U.S. Federal Reserve's actions, but what about its effects across borders? In this paper, we document the international spillovers of major central banks policies' through their indirect effect on a set of base asset prices, by using high-frequency identification of monetary policy announcements. We implement a gross domestic product (GDP)-tracking approach to identify real spillovers of monetary policy, by mimicking real GDP news based on our asset returns around monetary announcements. This reflects news regarding real GDP growth due to monetary policy. Using our approach, we find in response to positive, domestic monetary shocks, real GDP-tracking news becomes negative for Australia, Canada, and the United States. Our methodology indicates significant spillovers of U.S. monetary policy to asset prices in periphery countries, such as Australia and Canada, with a U.S. monetary contraction leading to a decrease in both of these countries' real GDP-tracking news.