A Hierarchical-Dealer-Centric Model of FX Swap Valuation

This paper constructs a model of foreign exchange (FX) swap valuation based on dealers’ behavior and the hierarchy of the global dollar funding system. International investors use these currency derivatives to synthetically fill their US-dollar funding gaps. In this model, three attributes of market structure drive the valuation of FX swaps: market-making costs (measured by dealers’ bid-ask spreads), dollar funding liquidity risk (measured by CIP deviation and market imperfections), and FX swap market liquidity (measured by dealer competition). The goal is to understand how market design influences the cost of US dollar funding and its spillover effects. FX dealers are vital institutions in this ecosystem, as their balance sheets connect national monetary systems to the global dollar funding markets. For currencies with low FX turnover, central banks act as market makers, while private banks serve as dealers for currencies with the highest FX turnover. Studying the “dollar funding gap” through the lens of FX swap dealers is a crucial aspect often overlooked in international finance scholarship.