Essays on Financial Intermediation and Foreign Exchange Rates

This dissertation consists of two independent but closely related essays that examine exchange rate dynamics by emphasizing the crucial role of financial intermediaries. The first chapter introduces the comprehensive background that establishes the motivation for the study. The second chapter investigates dollar exchange rate movements during the global financial crisis and the dynamics of the U.S external balance sheet. I propose a general equilibrium model such that financial intermediaries are subject to time-varying leverage constraints which limit their ability to raise funds. During global recessions, these constraints tighten, prompting investors to rebalance toward safer and more liquid assets, endogenously triggering a “flight to safety” that increases the demand of U.S Treasury bonds. This heightened demand raises the convenience yields of U.S Treasury bonds which in turn, leads to dollar appreciation. The model jointly explains the U.S exorbitant privilege during the global financial crisis through the safe asset view. The third chapter analyzes the role of financial intermediary constraints in pricing the cross sectional currency excess returns. Foreign exchange market is dominated by major global banks whose risk-bearing capacity is essential for absorbing and funding trading positions. Tightening intermediary constraints reduce their ability to take on risk, making them less willing to intermediate risky trades, thereby leading to higher risk premia. To empirically test the theory, I construct a novel index that captures the risk-bearing capacity of the global banks by combining both dealer-level measures and aggregate market indicators. The asset pricing analysis results show that intermediary constraint is a priced risk factor in explaining variation in currency excess returns. High interest rate currencies and currencies of external debtor countries with primarily foreign-currency denominated debts comove negatively with intermediary constraint risk factor, earning higher risk premia since they tend to perform poorly during periods of tightening financial constraints. In contrast, low interest rate net creditor country currencies offer lower average returns due to their role as a hedge, appreciating when intermediary risk-bearing capacity deteriorates. Together, these essays contribute to the literature with new approaches in understanding exchange rate dynamics and currency risk.