Bank foreign currency funding and currency markets: the case of Mexico post GFC

This paper examines the impact of foreign currency hedging demand on the foreign exchange market. First, the paper documents deviations from covered interest parity (CIP) for Mexico after the global financial crisis (GFC), and then it evaluates the effect of two variables in a regression-based analysis: (i) the FX funding gap of domestic bank balance sheets and (ii) external foreign currency hedging demand. The main result is that both variables directly influenced CIP deviations in Mexico, and it was robust to including arbitrage funding and foreign exchange transaction costs in the regression. These results suggest hedging demand can be an important factor in emerging economies' foreign exchange forward markets, even at short maturities. One of the implications is that banks' ability to manage the currency mismatch is affected by global shocks in the foreign currency market.