FX Swap Valuation As a Cost of Filling Dollar Funding Gap: A Hierarchical and Dealer-Centric Perspective

Abstract

This paper constructs a model of the FX swap valuation, the cost of synthetic dollar borrowing, based on the dealers’ behavior and the hierarchy of international finance. In this model, three fundamentals- market-making costs (measured by dealers’ bid-ask spreads), dollar funding liquidity risk (measured by CIP deviation), and the FX swap market liquidity (measured by the dealers’ competition)- derive the valuation of FX swap. The goal is to understand the financial instability spillovers between FX swaps and offshore US-Dollar funding markets through the “dealers” channel. FX dealers are vital institutions that connect different national monetary jurisdictions in the international monetary system. For currencies where FX turnover is low, market makers are central banks. On the other hand, those dealers are primarily private banks for currencies with the highest FX turnover, such as the US dollar. Nevertheless, studying the “dollar funding gap” through the lens of FX swap dealers is a feature that often gets overlooked in International Political Economy scholarship.