The Hedging Channel of Exchange Rate Determination

We propose the currency hedging channel that connects countries' external imbalances to their exchange rate behavior. We present a model in which investors increase their currency hedging during periods of financial distress, in proportion to their net foreign asset exposure. This behavior coupled with constrained financial intermediation explains observed relationships between gradually adjusting external imbalances and volatile spot and forward exchange rates. We find empirical support for the hedging channel in both the conditional and unconditional moments of exchange rates, option prices, and countries' uses of Federal Reserve swap lines. Additionally, we forecast currency returns using a hedging demand proxy.