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I would like to thank Peter Garber for insightful discussions. I would also like to thank Donald Mathieson, Bankim Chadha and Timothy Bond for valuable comments. The discussion of recent events in currency markets in this paper is based solely on anecdotal evidence, press reports, and conversations with market participants.
In the last few years, several well documented attacks have taken place, with varying results, such as in the United Kingdom, Sweden, Spain, France (all in 1992) and Mexico (1994). More recently, in 1997, speculative attacks have taken place in the Czech Republic and Thailand.
In analytical terms, agents wishing to hedge their foreign exchange short positions (such as on account of import payables or external debt service payments) would undertake similar strategies.
The history of securities markets is replete with episodes of markets corners and short squeezes. In October 1907, for example, a syndicate in New York attempted to corner the stock in a copper company. In response to the failed corner, the demand for liquidity increased and J.P. Morgan was able to implement a bear squeeze in the cash market on those short sellers attempting to access liquidity. See Garber and Weisbrod (1992) for an analytical treatment of market corners and Jordan and Jordan (1996) for a 1991 episode of a market corner in the U.S. Treasury market.
Reports include Reuters and other press reports, communication with market participants, and analyst reports.
The model is derived from Lall (1994) which develops the approach to speculative attacks with forward markets in a monetary model of exchange rate determination.
In an exchange rate crisis, taking short positions may be part of hedging activities or may be simply speculation for profit. Both activities imply taking an open position in currencies but the distinction between speculation and hedging may be somewhat blurred.
These concepts are developed analytically in Section 6.
Higher expected spot rate, in terms of the definition used in this paper, implies that the domestic currency price of unit foreign currency has increased.
The market forward rate means the bid-rate at which speculators can write forward contracts to deliver the weak currency to the commercial banking system.
et+i will be determined explicitly in Section 6, but the derivation has no bearing on the results of this section.
This is an assumption often made in the speculative attack literature.
A currency swap consists of a spot transaction resulting in the exchange of two principals and an offsetting reverse transaction some time in the future. A swap transaction by itself does not, therefore, imply an open position in a currency. However, if it is combined with an independent spot transaction in the opposite direction, there is a net delivery of currency forward and a net open position. In this sense, a spot and a swap transaction can be used simultaneously to create a synthetic forward contract. Figure 1 illustrates this point.
In addition, in the case of emerging markets, the devaluation of the currency can increase the domestic currency equivalent of foreign indebtedness of domestic entities, in particular the financial institutions. A devaluation may thus render many financial institutions insolvent or at the least illiquid, and require a costly financial bail-out from the central bank or the authorities. This is one of the important reasons why countries with fragile financial systems wish to avoid a devaluation that may overwhelm the financial system.
This again is related to the fragility of the financial system. Stronger financial systems are better able to withstand increases in interest rates whereas weaker ones will not be able to tolerate interest rate increases. Given the central banks’ roles as preserver of an orderly financial system, the central bank’s aversion to movements from a target interest rate is directly related to the resilience of the financial system.
Such a stochastic shock to the level of domestic credit was first introduced by Flood and Garber (1984).
While the empirically more relevant constraint may be that a central bank may not, in fact, have access to unlimited lines of credit, the collapse of a fixed exchange rate regime under those circumstances is hardly surprising. One intends to show in this model that even with unlimited access to credit over time, the exchange rate may collapse if central banks may face daily line limits on access to credit.
Forward market intervention is done at the target spot rate because central banks do not want to generate signals about future exchange rate policies. If central banks explicitly sell their own currency forward at a discount, it may affect expectations of speculators adversely and exacerbate an exchange rate crisis.
If intervention does not require shorting of reserves, the central bank can maintain the exchange rate and interest rate targets without facing foreign exchange losses, and the loss of the peg due to a stochastic shock will only cost the fixed amount associated with the loss of the exchange rate target.
Central banks intervene in the forward market at the official spot rate, because any other rate would be perceived by the market as a signal of future monetary policy and may therefore jeopardize the credibility of the monetary regime.
This condition has to hold, in general, in a fixed exchange-rate regime because fixed exchange rate would imply similar domestic and world and monetary policies.
This result is from Dixit (1991).
See, for instance, Jordan and Jordan (1996) for a description of Salomon Brother’s May 1991 attempt to corner the market in 2-year Treasury notes and its squeeze of that Treasury issue.
Short positions on the baht are more easily taken in the forward market because credit in the spot market is more difficult to access. The two primary sources of baht credit for the banking system from the central bank are the discount window and the repurchase facility. Both require collateral from a set of eligible securities which consist mostly of BOT bills and the bills of some state-owned enterprises (SOE). A small set of banks have assets in the form of BOT bills and SOE bills, and these banks pass credit through to the rest of the financial system.
The exception was if the banks could provide evidence of a documented trade or investment transaction for which credit was required by the off-shore counterparty. All cross-border transactions had from that date on to be reported to the BOT daily.
The result that longer-dated forward contracts have wider spreads than short-dated ones has been explained in this model even with risk-neutrality which is a significant departure from the existing literature which tries to explain it using risk-aversion of agents and a time-varying risk premium.