I was reading FX hedged investments do not have an impact on the FX rate. For example, a Japanese fund buying US treasuries fully FX hedged. I understand the hedging is usually done through short term FX swaps/forwards. Would you be able to explain why acquisition of foreign currency assets does not have an impact on the FX rate when the investment is FX hedged?
1$\begingroup$ Perhaps this was true in earlier theories of FX, but I think recently some research papers have argued that hedging does have an effect on exchange rate determination federalreserve.gov/econres/ifdp/… The amounts hedged nowadays are so large that it is IMHO not surprising that they can have an effect, especially on the behaviour of FX during crises when the desire to hedge increases $\endgroup$– nbbo2May 15, 2021 at 16:41
$\begingroup$ The Japanese investor is buying USD in the spot market and selling it in the forward market. Traditionally it was argued that "it all evens out" with no impact on the exchange rate but we now realize these are separate markets and banks may have limits on balance sheet capacity to arbitrage between them, so the "everything cancels out" theory may not be quite true. But this new view is controversial and not accepted by all (yet) ... $\endgroup$– nbbo2May 16, 2021 at 15:26
$\begingroup$ @noob2 I had a look at the paper you shared. Quite interesting! I have one question. On page 17 (20 of pdf), the author mentions: "the announcement of swap lines may instill more confidence in the financial sector and lower the overall balance sheet costs for swap intermediaries that are producing forward contracts" AND "provision of dollar liquidity can also reduce capital retrenchment and dollar hoarding, thereby reducing possible future exchange rate volatility and lowering institutional hedging demand.". Can you explain these 2 points? thanks $\endgroup$– StudentMay 22, 2021 at 18:44
$\begingroup$ In December 2007 and again in early 2020 the Federal Reserve announced Swap Lines to provide foreign central banks (and thus the banking system in those countries) with USD liquidity. Foreign banks that had been fearful of running out of money and had been cutting back on issuing forward contracts could feel more confident and resume this business. The investors in the financial sector (i.e. buyers of bank stocks) would also feel more confident, the price of bank shares would go up and again the banks could resume their activity of providing hedging. On the other side, hedgers would hedge less $\endgroup$– nbbo2May 22, 2021 at 19:05
$\begingroup$ ...since insurance cos and other insitutions believe that the Fed intervention means that the worst volatility may be over in exchange rates. $\endgroup$– nbbo2May 22, 2021 at 19:06
Forwards have a large impact on the spot market, swaps much less so. For example a 100m usd swap against mxn has a spot delta of less than 1m usd for all tenors less than a year ( and actually quite a bit longer in the current rate environment).
Where swaps do impact the spot market is in the cost of carry, large swap transaction drive the funding basis between the currency pairs in question and that determines the cost of keeping the spot position open or the price of the outright forward.