An intermediation-based model of exchange rates

BIS Working Papers  |  No 743  | 
14 September 2018



This paper sets out a macroeconomic model of international financial markets with market intermediaries such as brokers and dealers at its core. In our model, intermediaries use their market power to charge their customers a fee for providing them with trading access to foreign financial instruments. These additional costs ("rent extraction") distort the way that risks are shared internationally, altering both exchange rates and the prices paid for taking on or laying off risks. We show how this "intermediation friction" helps account for some major anomalies in foreign exchange and international capital markets.


Ours is the first model that shows how the market power of intermediaries can affect exchange rates. We explicitly link the dynamics of exchange rates to international risk factors and differences in expectations about how various countries will conduct their monetary policy. The model also explains why some countries will become safe havens, with currencies that strengthen in bad times. This is also the first model that shows how the normal relationship between interest rates and exchange rates ("covered interest parity") can break down in a widely used ("general equilibrium") macroeconomic model.


We find that demand for foreign exchange derivatives as a tool for insuring against the depreciation of a currency depends crucially on a country's exposure to global shocks as well as on how far its domestic monetary policy can act to stabilise the exchange rate. Differences between countries in their exposures to global shocks, as well as in the capacities of their financial sectors, help to explain why the US dollar serves as a safe haven currency, and also why it usually commands a premium in the foreign exchange swap market.



We develop a general equilibrium model with intermediaries at the heart of international financial markets. In our model, intermediaries bargain with their customers and extract rents for providing access to foreign claims. The behavior of intermediaries, by tilting state prices, generates an explicit, non-linear risk structure in exchange rates. We show how this endogenous risk structure helps explain a number of anomalies in foreign exchange and international capital markets, including the safe haven properties of exchange rates and the breakdown of covered interest parity.

JEL classification: E44, E52, F31, F33, G13, G15, G23

Keywords: financial intermediation, exchange rates, safe haven, covered interest parity deviations

Online appendix to "An intermediation-based model of exchange rates"