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Foreign institutional investors, monetary policy, and reaching for yield

Author

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  • Ahmed Ahmed
  • Boris Hofmann
  • Martin Schmitz

Abstract

This paper uses security-level data of euro area investment funds' bond holdings to analyze their reaching for yield in the US dollar bond market. We find that they rebalance their US dollar bond portfolios toward higher yielding, riskier bonds when US monetary policy tightens, reflecting the effects of foreign exchange hedging. The effect is driven by the practice of hedging currency risk through rolling short-term hedging contracts. This gives rise to an erosion of the hedged yield earned on US dollar bonds when US monetary policy tightens and hedging costs increase, inducing reaching for yield in order to bolster portfolio returns. The hedging channel of monetary transmission is diametrically opposed to the classical risk-taking channel operating through US dollar-based investors, where a monetary tightening is associated with less reaching for yield. We further find that the US dollar bond purchases by euro area investment funds induced by their reaching for yield have meaningful effects on bond prices, implying that they affect conditions in the US dollar bond market.

Suggested Citation

  • Ahmed Ahmed & Boris Hofmann & Martin Schmitz, 2023. "Foreign institutional investors, monetary policy, and reaching for yield," BIS Working Papers 1153, Bank for International Settlements.
    • Handle: RePEc:bis:biswps:1153
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    References listed on IDEAS

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    Cited by:

    1. Graziano, Marco & Habib, Maurizio Michael, 2024. "Mutual funds and safe government bonds: do returns matter?," Working Paper Series 2931, European Central Bank.

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    More about this item

    Keywords

    monetary policy; foreign institutional investors; FX hedging; US dollar bond market;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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