Summary
Focus
We highlight the central role of foreign exchange (FX) derivatives, particularly FX swaps and forwards, in facilitating cross-border bond investments and serving as a barometer for global spillovers of financial conditions. International investors use these instruments to manage currency risk when investing in foreign bonds. We emphasise how changes in FX derivatives activity – via their link to cross-border investment flows and monetary policy spillovers – reflect broader global financial conditions. Our aim is to understand how FX hedging activity connects bond markets across advanced economies and thereby acts as a conduit for the transmission of financial shocks globally.
Contribution
Our paper makes several important contributions to the literature on international finance and the global financial cycle. First, we provide new evidence on how FX derivatives enable cross-border bond investments, shedding light on their role as a key transmission mechanism for global financial shocks. Second, we highlight the importance of factors such as yield curve dynamics, hedging costs and risk appetite in driving FX derivatives activity. Third, we demonstrate how FX hedging by non-bank financial institutions, such as pension funds and investment funds, plays a critical role in linking financial conditions across advanced economies, including the United States, Europe and Japan. Guided by a simple two-country portfolio choice model, we test in the data the predictions on the interplay between FX derivatives, bond markets and global financial conditions.
Findings
We find that FX derivatives activity is closely tied to changes in bond market conditions. For example, a steeper yield curve in the United States tends to come with greater FX swaps usage, reflecting foreign investors hedging their investments in US bonds. Conversely, a flatter yield curve in other advanced economies encourages local investors to allocate funds to US bonds, leading to higher FX hedging demand. We also find that tighter financial conditions reduce FX derivatives activity, illustrating the sensitivity of these markets to shifts in global risk appetite. Importantly, our work highlights how monetary policy decisions in one country can have significant spillover effects on other economies, transmitted through FX-hedged bond investments. Our insights contribute to the understanding of the mechanisms driving the global financial cycle and highlight the importance of an observed quantity – shifts in the outstanding volumes of FX swaps and related FX derivatives – as both a barometer of and a conduit for international financial flows.
Abstract
We show that outstanding volumes in FX swaps serve as a good indicator for the hedging activity associated with portfolio positions of advanced economy bond investors. As such, FX swaps serve as a key barometer of risk-taking and global financial conditions. We develop a simple portfolio choice model for international bond investors and use it to estimate the relationship between global FX hedging activity, relative investment opportunities (captured by the yield curve slopes in respective economies), and the hedging costs associated with underlying investments. We find that higher FX hedging activity is closely associated with US portfolio debt inflows and outflows, indicating that FX hedging plays a crucial role in facilitating cross-border bond investments. This connection between FX hedging motives, portfolio bond flows, and the yield curve highlights a mechanism of international financial spillovers – not only from the US but also from advanced economies with significant accumulated wealth flowing into the US.
JEL classification: F31, F32, F42, G15
Keywords: global portfolio investments, FX hedging, financial conditions
