The Information Content in Bank Currency Mismatches in Fixed Exchange Rate Regimes

Banks tend to leave their currency exposures uncovered in fixed and “intermediate” exchange rate regimes. The paper asks why this is the case. There are three possible explanations: First, hedges are costly and the currency peg is credible; Second, financial markets are incomplete and so hedging instruments are unavailable; or third, hedges are costly and banks expect a bailout should currency gyrations threaten their solvency. The paper demonstrates that the third argument is not time consistent and therefore that uncovered currency exposures reflect currency peg credibility or financial incompleteness and not moral-hazard risk taking.