Pension fund flows exchange rates and covered interest rate parity

Frequent, yet uninformed, market timing recommendations by a financial advisory firm generate significant flows for Chilean pension funds. These flows give rise to substantial changes in the Chilean foreign exchange due to the funds’ high allocation to international equities. Hedging by local banks propagates the demand fluctuations from the spot to the forward currency market and results in deviations from covered interest rate parity. Using bank balance sheet data, we confirm that banks’ risk bearing constraints create limits to arbitrage.