We study the implications of deviations from covered interest rate parity for international capital flows using novel data covering euro-area derivatives and securities holdings. Consistent with a dynamic model of currency risk hedging, we document that investors’ holdings of USD bonds decrease following a widening in the USD-EUR cross-currency basis (CCB). This effect is driven by investors who need to roll over existing positions, and it is robust to instrumenting the CCB. These CCB-driven shifts in bond demand significantly affect government bond prices. Our findings shed new light on the determinants of international capital flows and have important consequences for financial stability.

How do exchange rates affect the asset allocation of bond portfolio investors? Using detailed security-level holdings, we find that euro area-based investors systematically shed sovereign bonds as the dollar strengthens, confirming the role of the dollar as a global risk factor even for euro-based investors. More distinctively, they also shed local currency bonds when the euro strengthens, due to currency mismatches on their own balance sheets. There is no such effect for foreign currency bonds of the same sovereign issuers. These findings are consistent with a Value-at-Risk portfolio choice model that brings out separate roles for local, foreign and reference currencies.

Are foreign exchange interventions effective at moving exchange rates? In this paper, we leverage the rebalancings of a local-currency government bonds index for emerging countries as a quasi-natural experiment to identify the required size of foreign exchange interventions to stabilize exchange rates. We show that the rebalancings create large and exogenous currency demand shocks that move exchange rates. Our results provide empirical support for models of inelastic financial markets where foreign exchange intervention serves as an additional policy tool to effectively stabilize exchange rates. Under inelastic financial markets, a managed exchange rate does not have to compromise monetary policy independence even in the presence of free capital mobility, relaxing the classical trilemma constraint. We show that countries with a free-floating exchange rate regime (free floaters) are more than twice more effective at stabilizing exchange rates than are countries with a managed exchange rate regime. This is because the volatile exchange rates for the free floaters lead to more inelastic financial markets and generate further departure from the trilemma.