Working Paper: NBER ID: w4982
Authors: Richard K. Lyons; Andrew K. Rose
Abstract: Intraday 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 defense. In equilibrium, however, buyers of the vulnerable currency must be compensated on average with an intraday capital gain as long as no devaluation occurs. That is, currencies under attack should typically appreciate intraday. Using data on intraday exchange rate changes within the EMS, we find this prediction is borne out.
Keywords: foreign exchange market; intraday trading; interest rates; currency crisis
JEL Codes: F31; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| absence of intraday interest rates (E43) | costless means of speculating against vulnerable currencies (F31) |
| expected cost of shorting a currency in crisis (F31) | offsets expected gains from devaluation (F31) |
| higher weak-currency interest rate reflecting greater expected devaluation (F31) | greater expected appreciation (conditional on no devaluation) (F31) |
| higher weak-currency interest rate (E43) | greater expected appreciation (D84) |
| higher weak-currency interest rate (E43) | greater expected devaluation (F31) |
| intraday changes in exchange rates (F31) | interest differentials (E43) |