We study the implications of deviations from covered interest rate parity for international capital flows using novel data covering euro-area derivatives and securities holdings. Consistent with a dynamic model of currency risk hedging, we document that investors’ holdings of USD bonds decrease following a widening in the USD-EUR cross-currency basis (CCB). This effect is driven by investors with larger FX rollover risk and hedging mandates, and it is robust to instrumenting the CCB. These shifts in bond demand significantly affect bond prices. Our findings shed light on a new determinant of international capital flows with important consequences for financial stability.
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