The usual prescription for the defense of a fixed exchange rate during a speculative attack is aggressive sales of foreign currency on the spot and forward markets, combined with increases in short-term interest rates of a sufficient magnitude to squeeze speculators who are short in the currency. Two developments in international financial markets in recent years may have reduced the effectiveness of this advice. First, institutional and other large investors have diversified their portfolios internationally. Consequently, the potential exposures to currency risk are growing, and also the potential selling pressure if the ability of the authorities to maintain a fixed exchange rate comes into question. Second, the growth in the markets for foreign exchange derivatives has both improved the ability of investors to hedge their exposures and provided instruments through which speculators can take highly leveraged positions against weak currencies.
This paper discusses the possibility that the operations of banks and nonbanks to hedge their currency exposures may weaken the effectiveness of the classic interest rate defense. The focus is on market and central bank behavior in the last moments of a fixed exchange rate regime. In addition to providing powerful tools for speculation, options-pricing models can be used by banks and investors to construct synthetic currency put options by trading regularly in the cash markets. These synthetic options provide a hedge against exchange rate changes if the positions can be adjusted continually. In the presence of this dynamic hedging, an increase in interest rates to defend against a speculative attack may automatically trigger even more selling of the currency that is under attack. The paper finds that interaction between the timing of different trading strategies--dynamic hedging programs and the reaction of speculators who are caught by the interest rate increase--is crucial to the outcome of the central bank’s policy. If the volume of selling motivated by dynamic hedging overwhelms that of the purchases by speculators seeking to close out their positions, the central bank may reach its credit limits with commercial banks or its own position limits, forcing It to abandon the fixed exchange rate. However, raising rates gradually in an interest rate defense may immunize the central bank against being pushed beyond its position limits.