The additional cost of hedging in foreign currency loans

Foreign currency denominated loans (FCDLs) are an important part of corporate funding as well as an operational risk management tool. We show that domestic borrowers use FCDLs to hedge their foreign exchange risk exposure. FCDLs are found to carry an interest rate premium over domestic currency loans after controlling for borrower characteristics, loan characteristics, and macroeconomic conditions. We argue that borrowers are willing to pay this premium since the marginal benefit of FCDLs as a natural hedge outweighs the marginal cost. From a lender’s perspective, this premium reflects a compensation for additional foreign exchange risk exposure and intensified monitoring efforts. These results are robust to endogeneity-corrected estimations.