Risk, Specialization, and Covered-Interest Parity

Abstract

Prevailing theories of financial intermediation assume an integrated financial sector with frictionless risk-sharing. However, we identify substantial risk-sharing frictions linked to intermediary specialization using currency derivatives markets as a laboratory. Using confidential supervisory data covering $25 trillion in daily bank exposures, we document imperfect hedging in banks' FX-swap intermediation: banks rarely hedge their synthetic dollar lending with maturity-matched foreign safe assets. Intermediaries specialize in markets in which they have expertise in managing the associated exposures, giving rise to cross-market variation in deviations from covered-interest parity. Our results highlight the importance of intermediary specialization and its impact on risk premia.