Abstract: US dollar funding is crucial to the functioning of the global economy. However, the sources of and frictions in the international supply of the dollar are not well understood. In this paper, I show that foreign exchange (FX) swaps emerge as alternative ("synthetic") dollar funding instruments when its wholesale supply is constrained. Global banks increase dollar borrowing via FX swaps in response to reduced flows from US money market funds, which leads to substantial deviations from covered interest parity (CIP). I construct granular instruments using money market funds’ investments in bank-issued debt and find that CIP deviations worsen when large foreign banks face negative shocks to wholesale dollar funding. This shift in aggregate demand is absorbed by non-bank users of FX derivatives in the form of higher hedging costs: I estimate the elasticity of non-bank investors' hedging demand to CIP deviations and find only a partial adjustment in quantities traded. Likewise, the incremental supply of dollars from cash-rich US institutional investors, who can profit from CIP deviations, is not large enough to offset the price impact. My results indicate that frictions in the global market for the US dollar provide a demand-based explanation for the violation of no-arbitrage pricing conditions.
The Market for Sharing Interest Rate Risks: Quantities and Asset Prices
(with Jian Li, Ioana Neamtu, Ishita Sen)
Abstract: We study interest rate risk sharing across the financial system using novel data on cross-sector interest rate swap positions. We show that pension funds and insurers (PF&I) are natural counterparties to banks and corporations: PF&I buy duration, whereas banks and corporations sell duration. However, demand is highly segmented across maturities, resulting in significant imbalances at various maturity points. We calibrate a preferred-habitat investors model with risk-averse arbitrageurs to study how demand imbalances interact with supply side constraints to impact swap spreads. Our framework helps quantify the spillover effects of demand shifts, which informs policy discussions on financial institutions’ hedging requirements.
Corporate Trading in Over-the-counter FX Markets
(with Petra Sinagl)
Abstract: We examine the role of multinational corporations in explaining the extraordinary volume and price volatility in foreign exchange (FX) markets. Corporations represent a distinct segment of discretionary traders with negatively correlated order flow to that of informed agents, which allows for internalization of dealers’ inventory. However, liquidity shocks experienced by them contribute to a “hot potato effect”: the repeated passing of dealers’ inventory imbalances. Using settlement breaks to instrument for quasi-exogenous shocks to liquidity-motivated trading, we find that a dollar increase in corporate volume leads to more than two dollars being exchanged in the inter-dealer segment. This hot potato effect exacerbates noise in currency prices, with a one standard deviation rise in corporate order imbalance leading to a 22% increase in return volatility. In contrast to other traders, spreads paid by corporations increase with volume, suggesting that dealers view large corporate flows as a source of inventory risk.
Unemployment Insurance Fraud in the Debit Card Market
(with Jetson Leder-Luis, Jialan Wang, Yunrong Zhou. NBER working paper # 32527)
Abstract: We study fraud in the unemployment insurance (UI) system using a dataset of 35 million debit card transactions. We apply machine learning techniques to cluster cards corresponding to varying levels of suspicious or potentially fraudulent activity. We then conduct a difference-in-differences analysis based on the staggered adoption of state-level identity verification systems between 2020 and 2021 to assess the effectiveness of screening for reducing fraud. Our findings suggest that identity verification reduced payouts to suspicious cards by 27%, while non-suspicious cards were largely unaffected by these technologies. Our results indicate that identity screening may be an effective mechanism for mitigating fraud in the UI system and for benefits programs more broadly.
Process Innovation and the Corporate Control Market
(with Amrita Nain)
Abstract: We show that specificity of process innovation affects merger decisions. We measure the composition of a firm’s innovation portfolio by machine-reading 90 million patent claims and show that firms with a higher share of process innovation generate more firm-specific knowledge: they are more likely to cite their own past patents, employ inventors who have more within-firm patenting experience, and exploit technologies already known to them rather than explore new ones. While process innovation is value-enhancing for the stand-alone firm, its specificity reduces synergistic gains from an acquisition. We find robust evidence that process innovators are significantly less likely to be acquired. Consistent with the specificity explanation, the negative effect of process innovation on acquisition likelihood is dampened if the bidder manufactures similar products and, therefore, can apply the target’s innovative processes to its own product line. Our study provides the first large-sample evidence on the fungibility of innovation and its impact on mergers and acquisitions.