Working Paper: CEPR ID: DP1059
Authors: Richard K. Lyons; Andrew K. Rose
Abstract: Intra-day interest rates are zero. Consequently, a foreign exchange dealer can short a vulnerable currency in the morning, close this position in the afternoon, and never face an interest cost. This tactic might seem especially attractive in times of crisis, since it suggests an immunity to the central bank's interest rate defence. In equilibrium, however, buyers of the vulnerable currency must be compensated on average with an intra-day capital gain, as long as no devaluation occurs. That is, currencies under attack should typically appreciate intra-day. Using data on intra-day exchange rate changes within the European Monetary System, we find this prediction is borne out.
Keywords: foreign exchange crises; interest rate defense; returns
JEL Codes: F31; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| absence of interest cost (G32) | increased short selling of vulnerable currencies (F31) |
| buyers of vulnerable currency must receive compensation (F31) | intraday capital gains (G14) |
| no devaluation occurs (F31) | vulnerable currencies appreciate intraday (F31) |
| greater probability and size of devaluation (F31) | greater implied appreciation of the currency (F31) |
| higher interest differentials (E43) | greater intraday appreciation of weak currency (F31) |
| absence of interest cost (G32) | immune to punitive domestic interest rates (E43) |