Non-Fundamental Flows and Foreign Exchange Rates

Frequent, yet uninformed, fund flows in Chilean pension plans generate substantial trading in currency markets due to the plans’ high international diversification. These non-fundamental flows have a significant impact on the Chilean exchange rate, which is estimated to have a relatively low price elasticity of 0.81. Hedging by the banking sector propagates the price pressure to currency forward markets and results in violations of the covered interest rate parity (CIP). Using bank balance sheet and trading data, we confirm that regulatory capital requirements and banks’ risk bearing constraints create limits of arbitrage.