LO 77.3: Discuss the US dollars role as the measure of the appetite for leverage.

LO 77.3: Discuss the US dollars role as the measure of the appetite for leverage.
We already noted that the VIX is no longer a reliable gauge of leverage. In recent years, the U.S. dollar emerged as a viable alternative to the VIX. During periods with a weak dollar, risk appetite tends to be strong. With a strong dollar, risk appetite is weak and market anomalies like the breakdown of CIP occur more frequently. This inverse relationship is readily apparent when comparing the value of the dollar (or of the dollar/euro exchange rate) against the cross-currency basis of a basket of advanced economy currencies over the last few years. As the dollar appreciated, the cross-currency basis widened. The relationship is particularly true since 2014, which marked the beginning of a strong dollar appreciation. The wider basis can be seen as an incremental cost of borrowing in dollars (i.e., wider basis, higher cost).
Any deviation from CIP can be interpreted as the price that banks place on leverage. Any gap between the CIP implied rate and actual rate would represent a profit potential for the banks, borrowing at a low rate and lending at a higher rate, while fully hedging currency risk. The fluctuation in the cross-currency basis in effect implies an opportunity cost (money left on the table) for banks and could be seen as a pressure of forced deleveraging.
What is clear is that following the financial crisis, the dollar has replaced the VIX as the reliable measure of the price of bank balance sheet and leverage. The dollar now functions as a risk factor that effectively prices the CIP deviation.
Why is the Dollar a Good Measure of Leverage?
In recent years, interest rates have fallen considerably around many parts of the world. U.S. assets, however, have remained above many advanced economy asset returns. As a result, investors have increased their demand for higher yielding assets denominated in U.S. dollars. However, this creates a currency mismatch and risk for institutional investors who hold dollar investments but have commitments to domestic stakeholders. For example, a German life insurance company has domestic currency (euro) obligations to its policyholders and beneficiaries. If the life insurance company has an investment portfolio denominated in dollars, it is exposed to volatility in the value of the dollar, and will therefore hedge any dollar currency risk. Hedging is typically done through a local bank that provides hedging services. The bank will also want to hedge its own currency risk by borrowing in dollars. As a result, the global dollar intermediation will mirror currency hedging demands.
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Topic 77 Cross Reference to GARP Assigned Reading – Shin
Th e Im pa c t o f D o l l a r St r e n g t h e n in g