The Hedging Channel of Exchange Rate Determination.

The article focuses on the "currency hedging channel," a mechanism linking countries' external dollar-denominated imbalances to exchange rate dynamics through investors' time-varying currency hedging behavior and constrained financial intermediation. It presents a theoretical model and empirical evidence from G-10 currencies showing that investors increase their currency hedge ratios during periods of heightened exchange rate volatility in proportion to their net U.S. dollar debt holdings, which affects both spot and forward exchange rates, cross-currency bases, and currency option prices. The study highlights that countries with positive dollar imbalances experience domestic currency appreciation and more negative cross-currency bases during volatile periods, while those with negative imbalances see the opposite. Empirical analyses include the impact of the Solvency II insurance regulation, which increased hedging demand and widened currency bases in affected regions, and the use of Federal Reserve dollar swap lines during the COVID-19 crisis, which were drawn more by countries with positive dollar imbalances consistent with hedging needs. Overall, the currency hedging channel provides a quantitatively significant explanation for exchange rate behavior, risk premiums, and the term structure of currency basis in international financial markets.