The Perfect Storm: Bank of Israel’s Forex Interventions, Global Banks’ Limited Risk-Bearing Capacity, Deviations from Covered Interest Parity, and the Impact on the USD/ILS Options Market
Using confidential daily foreign exchange interventions (FXI) data, we analyse the FXI episode of the Bank of Israel (BOI) from 2013 to 2019. We find that a purchase of US dollar (USD) 1 billion is on average associated with a depreciation of the Israeli new shekel (ILS) by 0.82%-0.83%, which is at the upper bound of the estimated impact in other studies. We show that this effectiveness can be explained by global financial intermediaries’ limited risk-taking capacity. The (indirect) effect on the forward rate is smaller-the BOI’s USD purchases have widened the negative deviation from covered interest parity. This widening remains significant over 90 days. Contrary to the findings in earlier empirical literature, the higher moments of the risk-neutral probability distribution of future spot exchange rates are also affected. The USD purchases shift the whole distribution towards higher USD/ILS values while reducing crash risk. We also find that the USD/ILS options market partially anticipates intervention episodes and prices them in before they occur.
@article{hertrich2023perfect,title={The Perfect Storm: Bank of Israel’s Forex Interventions, Global Banks’ Limited Risk-Bearing Capacity, Deviations from Covered Interest Parity, and the Impact on the USD/ILS Options Market},author={Hertrich, Markus and Nathan, Daniel},year={2023},dimensions={true},}
Accepted for publication at the Journal of Banking and Finance
We investigate daily flows to Israeli government bonds mutual funds, which are held primarily by retail investors. We divide the bonds into six categories: nominal/CPI-linked; short-term, intermediate-term, and long-term maturity. We find that daily net flows are contemporaneously correlated with price changes of all categories. These price changes are economically significant and they subsequently reverse fully or mostly within 10 trading days. The price reversal indicates that the initial price changes are due to “noise.” We also find that these price distortions affect break-even inflation—a popular measure of inflation expectations. Our findings indicate that even securities that are held by institutions and professional investors are affected by retail sentiment.
@article{abudy2021mutual,title={Mutual Fund Flows and Government Bond Returns},author={Abudy, Menachem Meni and Nathan, Daniel and Wohl, Avi},year={2022},note={Accepted for publication at the Journal of Banking and Finance}}
SSRN
Shorting the Dollar When Global Stock Markets Roar: The Equity Hedging Channel of Exchange Rate Determination
This paper investigates the influence of global equity market shocks on institutional investors’ (IIs’) hedging behavior and the resulting effects on exchange rates. Employing unique daily data on Israeli IIs’ foreign exchange (FX) forward flows, we find that a one standard deviation global equity market shock generates significant and persistent selling of US dollar forwards by IIs, as a hedge against heightened FX exposure, along with significant and persistent exchange rate appreciation. To reinforce the causal interpretation of our findings, we use both a granular instrumental variable estimation approach as well as a Bartik instrument one to show that IIs’ hedging demand shocks induce significant exchange rate appreciation.
@article{ben2022shorting,title={Shorting the Dollar When Global Stock Markets Roar: The Equity Hedging Channel of Exchange Rate Determination},author={Ben Zeev, Nadav and Nathan, Daniel},year={2022},dimensions={true},}
SSRN
The Persistent Widening of Cross-Currency Basis: When Increased FX Swap Demand Meets a Shortage of Global Arbitrage Capital
Revise and Resubmit at the Journal of International Economics
This paper examines customer demand-side factors that affect deviation from covered interest rate parity (CIP) with respect to the dollar (i.e., cross-currency basis), particularly when arbitrageurs are constrained. Using novel detailed daily transaction-level data on the universe of Israeli institutional investors (IIs), we employ a granular instrumental variable (GIV) estimation to investigate how IIs’ FX swap demand affects CIP deviation. Our findings demonstrate that a one standard deviation shock to IIs’ FX swap demand when capital is abundant has a null effect on IIs’ basis. However, when capital is scarce, the demand shock produces significant and persistent reduction of 3.9-8.4 basis points in IIs’ basis, remaining significant for over 500 trading days.Our results, which are unchanged when we consider the complementary and popularized Bartik instrument approach instead of the GIV one, showcase how limits of arbitrage, together with demand shocks from a large customer base, can drive CIP deviations.
@article{nathan2022persistent,title={The Persistent Widening of Cross-Currency Basis: When Increased FX Swap Demand Meets a Shortage of Global Arbitrage Capital},author={Nathan, Daniel and Ben Zeev, Nadav},dimensions={true},year={2022},note={Revise and Resubmit at the Journal of International Economics}}
SSRN
Exchanges for Government Bonds? Evidence during COVID-19
We leverage the unique institutional feature that the Israeli government bond market operates on an exchange rather than over-the-counter to analyze whether and why having an exchange affects market liquidity during a crisis. We document how the liquidity crisis in March 2020 affected the Israeli government bond market, and conduct difference-in-differences analyses, comparing bid-ask spreads in exchange markets (such as the Israeli government bond and U.S. future market) with markets lacking an exchange (like the U.S. government bond market). Our findings support the idea that having an exchange enhances market liquidity. A counterfactual analysis using trade data from the Israeli exchange suggests that this is due to the ability of investors to readily provide liquidity to one another and the efficient netting of trade flows on an exchange.
@article{kutai2022exchanges,title={Exchanges for Government Bonds? Evidence during COVID-19},author={Kutai, Ari and Nathan, Daniel and Wittwer, Milena},dimensions={true},note={Revise and Resubmit at Management Science},year={2022}}
2018
SSRN
Decomposing the Term Structure of Interests Rates: Evidence from a Small Open Economy
Revise and Resubmit at the International Journal of Central Banking
This paper uses Israeli data of inflation-indexed and nominal government bonds to estimate a discrete-time essentially affine term structure model. To estimate the model, I use a uniquely long-spanned sample of monthly real yields for the period of 01/1985-03/2018. The nominal yields data spans the period of 05/2001-03/2018. I document an unconditional upward sloping real term structure that the model ascribes to a rising real term premium while the average expected real short rates are relatively flat. A decomposition of the break-even inflation shows that the unconditional term structure of the inflation premium is increasing with maturity and most of the variance in the short end is due to expected inflation. However, in the long end, most of it is due to the inflation term premium.
@article{nathan2018decomposing,title={Decomposing the Term Structure of Interests Rates: Evidence from a Small Open Economy},author={Nathan, Daniel},dimensions={true},year={2018},note={Revise and Resubmit at the International Journal of Central Banking}}