Interest Rate Differences, Forward Exchange Mechanism, and Scope for Short-Term Capital Movements

WITH THE RELAXATION of exchange controls and the rapid rise in the volume of international trade over the last few years, there has developed both a very large supply of money, which is shifted from one international monetary center to another in search of higher interest rates, and a large volume of demand for money, which shifts in search of lower interest rates. Together, these shifts can subject a country whose interest rates become relatively low to rapid and large losses of gold and foreign exchange reserves. Even though the country’s longer-run position is not unsound, such losses may provoke speculative flights of “hot money,” which could place the exchange rate in jeopardy.


WITH THE RELAXATION of exchange controls and the rapid rise in the volume of international trade over the last few years, there has developed both a very large supply of money, which is shifted from one international monetary center to another in search of higher interest rates, and a large volume of demand for money, which shifts in search of lower interest rates. Together, these shifts can subject a country whose interest rates become relatively low to rapid and large losses of gold and foreign exchange reserves. Even though the country’s longer-run position is not unsound, such losses may provoke speculative flights of “hot money,” which could place the exchange rate in jeopardy.

WITH THE RELAXATION of exchange controls and the rapid rise in the volume of international trade over the last few years, there has developed both a very large supply of money, which is shifted from one international monetary center to another in search of higher interest rates, and a large volume of demand for money, which shifts in search of lower interest rates. Together, these shifts can subject a country whose interest rates become relatively low to rapid and large losses of gold and foreign exchange reserves. Even though the country’s longer-run position is not unsound, such losses may provoke speculative flights of “hot money,” which could place the exchange rate in jeopardy.

Failure to anticipate these results of a relaxation of exchange controls in an environment of stable exchanges is explained, in part, by a belief that the international shifts of short-term lendings and borrowings actually carried out would be limited to a small fraction of the amounts that lenders and borrowers desired to make. The cause of this limitation was found in a restricted availability of forward foreign exchange; and forward exchange is a necessary ingredient in a major part of the short-term lendings or borrowings that respond to differences in interest rates.

This paper will describe how the opportunity for large movements of short-term funds can be provided by the normal responses of exporters and importers to movements in the forward exchange rate. It will also note some implications of the situation for three alternative means of dealing with the capital movements: official operation in the forward market, widening the legal range of variation of the exchange rate (widening the spread between the “gold points”), and enlarging the narrower range within the gold points over which the exchange rate actually is permitted to move.

Role of Forward Exchange in Short-Term Capital Movements

Movements of short-term capital in response to international differences in interest rates are normally dependent on protection against unfavorable movements in exchange rates. An extra interest yield of 1 per cent on three-month Treasury bills of the United Kingdom would be entirely canceled out if the pound were to depreciate just ¼ percentage point before the funds invested in the bill could be repatriated.1

The accepted view has been that the amount of a currency which holders of foreign balances can contract now to buy at some date in the future, as a protection for exchange transactions, is normally rather inflexible. To obtain agreement from others to make a future sale of domestic currency in exchange for foreign currency temporarily held, the holder of short-term balances might have to pay not only the going exchange rate but also a premium. If arrangements to purchase large additional amounts of domestic currency were to be made, this premium would be pushed so high that it would more than cancel out any possible advantage secured from the higher short-term interest rate of the foreign country. Hence, it has been thought that the volume of “covered interest arbitrage” transactions normally could be no more than “small,” and that most of any large volume of short-term capital movements observed would have to be explained by motives other than a desire for higher interest yields.2 Precisely this reasoning has been offered in criticism of an increase in short-term rates carried out by the United States in July 1963 for the purpose of attracting short-term funds.3

Variability in Use of Forward Cover for Current Account Payments

Monetary relationships among the main money-market currencies were uncertain and disturbed during the whole period from before World War II until late in 1958. In these conditions, a theory of forward exchange markets was developed which assumed that all those who undertook nonspeculative short-term dealings in foreign exchange would normally obtain exchange rate protection. This view has persisted even since the main European currencies acquired external convertibility in 1958.

The new element in the foreign exchange market, which made necessary a revision of previous opinion, was the restoration of confidence in the maintenance of the official parities: importers and exporters—who have probably been the chief users of forward exchange contracts—became confident in 1959 that, for example, the dollar price of the pound sterling would not move (within the next three months) outside the legal limits of $2.78 and $2.82. The narrow movements in the forward exchange rate which would make forward exchange ¼ per cent cheaper, or ¼ per cent more expensive, than spot exchange thus became a matter of importance for the trader. Previously, he had felt that he had to conduct most, if not all, of his foreign exchange operations through the forward market, and to ignore the spot market almost completely. Movements of ¼-½ per cent in the forward rate therefore had little influence on his exchange transactions—as little influence as equal spot rate movements are assumed, by the theory of international trade, to have on those exports and imports for which the spot exchange market is used. But once confidence was established in the limits of $2.78 and $2.82 for the pound (which restrict its range of variation to a mere 1.4 per cent), the trader who was not interested in foreign exchange speculation would realize that, under some conditions, use of the forward market would be advantageous, and that under others, resort to the spot market at the time of payment would be preferable.

This is understood most easily if it is assumed that the trader has an idea that the most likely value for the spot rate three months hence is the same as the current spot rate. If, under these circumstances, a U.S. importer of goods from the United Kingdom were to pay a premium of 1 cent for forward pounds (e.g., $2.81½ when the spot rate is $2.80½) rather than wait to buy spot pounds when the payment is due, he would be buying insurance, against possible variations in the exchange rate, at a price equal to two thirds of the maximum possible loss against which he is insuring (1½ cents, since the spot pound could rise to only $2.82). However, rather than pay a premium of 1 cent for insurance against a loss whose maximum would be 1½ cents, many importers of U.K. goods would refrain from covering forward. The reasons for such a decision are especially persuasive because the purchase of forward cover would not only be an insurance against the loss caused by an appreciation of the spot pound but would also eliminate the profit which would accrue if the spot rate for the pound should fall below the existing rate of $2.80½. At the upper limit of $2.82, the U.S. importer could never gain by covering forward, and he probably would lose; at this price, therefore, his demand for forward pounds would be zero. At $2.78, by similar reasoning, he would buy forward cover for all his imports. (The preceding discussion applies equally if the import is to be paid for in dollars; the U.K. exporter, who expects to receive dollar payments, would then do the forward covering, and would make similarly large adjustments in his purchases of forward pounds in response to very small movements in the forward rate.)

Expressed in more general terms, the purchase of forward cover at a premium constitutes acceptance of an exchange loss now in order to eliminate the chance of a possible greater loss later. But once the size of the later loss has been restricted to a figure which could not jeopardize continuation of the trader’s activities, the choice between the two losses becomes purely a matter of probabilities. And when the probabilities are against accepting a loss now, the trader who does accept it more nearly resembles a “speculator,” for he is gambling on an unlikely outcome. In a sense, his behavior is even more speculative than that of the gambler: the gambler at least has the hope of a quick win which will permit him to stop betting before the unfavorable probabilities can assert themselves, whereas the trader knows that he must keep on betting for a period long enough to have the unfavorable probabilities take effect. Thus, when existing exchange parities are trusted, the usual view that traders are not interested in exchange rate speculation requires acceptance of the fact that the extent to which foreign exchange risks are covered does vary according to the cost of cover.

When the trader cannot select any spot rate, such as the current figure, as the most probable value for the spot rate three months hence, the only factors relevant to his decision are the current forward rate and the gold points. This requires a revision of the reasoning just presented. Assume, for example, that the trader normally considers that all spot rates between $2.78 and $2.82 have equal probabilities of being realized in three months. In that event, a trader having numerous, frequently repeated import transactions will know that he will gain by buying forward pounds at a price below $2.80 and lose if he buys at a price above $2.80. Given the uncertainties of his assumed probability distribution at any particular time, the trader will not feel justified in switching from full to zero use of forward cover as soon as the price of the forward pound rises above $2.80. Instead, he will make gradual adjustments as the excess of the forward rate above $2.80 increases. He will seek no forward cover for his imports when the forward rate is $2.82, but will seek complete cover when it is $2.78.

A reasonable inference from the preceding is that, if the action of interest arbitragers should cause the forward pound to depreciate by as little, say, as ⅓ per cent (e.g. from $2.81½ to $2.80½), traders would make very large net purchases of forward pounds, or large reductions in the net sales of forward pounds which they would otherwise be making. This means—in contrast to the popular view—that holders of short-term funds in other centers who might wish to take advantage of higher U.K. interest rates would find that a large volume of forward pounds could be sold for forward dollars at the sacrifice of relatively little of the extra interest earnings obtainable in the United Kingdom.4

The preceding discussion is made more explicit by Diagrams 1 and 2. Diagram 1 shows how the importers’ and exporters’ (“traders’”) net demand curve for forward sterling is derived from the volume of trade and the position of the forward exchange rate. The diagram is drawn on the simplifying assumption that exports and imports are equal, each being oa over a three-month period.

At the upper limit of £1 = $2.82, no U.S. importer who had confidence in the £/$ parity and gold points for the next three months would buy sterling in the forward market. If the forward pound fell to the lower limit of $2.78, all importers would buy forward sterling. This would imply—on the assumption that import payments are covered three months forward—that importers would (after a three-month transition period) be holding forward contracts equal to the value of one fourth of a year’s imports. Exporters expecting to receive payments in sterling would sell all that sterling forward when the forward rate was $2.82, but none when the rate was $2.78.

The excess of the U.S. importers’ forward purchases over the U.S. exporters’ forward sales at any given rate is the traders’ net demand for forward pounds, Dtrad. Thus, in Diagram 1, the net demand at an exchange rate of £1 = $2.79 (o’e) is equal to the gross demand (o’f) minus the supply (o’b).

The traders’ net demand curve is shown also in Diagram 2, on which the ordinate represents not the absolute number of forward dollars a pound but four times the percentage discount of the price of forward pounds below the price of spot pounds. Thus, if the spot price were $2.80, a forward price of $2.79 would be shown in Diagram 2 as a 1⅓ per cent discount:

$2.79 $2.80$2.80× 4 = approximately 1 per cent.

We may now consider the supply of forward pounds offered by interest arbitragers—a supply which is assumed to be equal to the short-term funds that they transfer to the United Kingdom. (This discussion assumes that dollar balances are placed in loans denominated in sterling; the same reasoning applies, however, where—as with some Euro-dollar deposits and loans by U.S. banks—the loan is fixed in dollars and the borrower is left to convert it into sterling and offer the forward pounds.) The curve Sarb in Diagram 2 represents the arbitragers’ supply of forward pounds; it is drawn on the assumption that funds placed in the United Kingdom may be removed in three months. This curve is assumed to be very elastic at first but to become inelastic as more of the available liquid balances are transferred to the United Kingdom. If the discount on the forward pound below the spot pound is 1 cent (approximately ⅓ per cent), the purchase of spot pounds and subsequent repurchase of dollars through a forward contract would yield a loss of ⅓ per cent of the funds invested. Since the funds were invested for a period that might well be only three months (one quarter of a year), this loss would cancel out the benefit derivable from a U.K. interest rate that was higher by 1⅓ per cent per annum than the rate earnable on an alternative investment in the United States. In other words, if the short-term interest rate in the United Kingdom exceeds that in the United States by 1⅓ per cent, the arbitragers’ supply of forward pounds falls to zero when 4 times the discount of the pound’s forward value in terms of dollars below its spot value is 1⅓ per cent; reductions in the forward discount induce an increasing supply of forward pounds from arbitragers. When the three-month interest rate in the United Kingdom exceeds the U.S. rate by less than 1⅓ per cent, the supply of pounds by arbitragers falls to zero at a smaller discount on the forward pound than ⅓ per cent. The Sarb curve is then higher, and the volume of funds placed in the United Kingdom is, of course, smaller.

The superimposition of the Dtrad curve on the Sarb curve of Diagram 2 raises certain problems. The independent variable in Diagram 2 is the discount of the forward rate relative to the spot rate, whereas the independent variable determining trader demand in Diagram 1 is the level of the forward rate relative to the gold points (or simply the absolute level of the forward rate). As described earlier, the trader’s demand for forward exchange is probably a function of both these variables. It is permissible, therefore, to express Dtrad as a function of the forward discount alone (Diagram 2) only if the level of the spot rate is constant. For example, an appreciation of the spot rate that was accompanied by an equal rise in the forward rate would leave the forward discount unchanged; Diagram 2 would therefore show no change. But, from the relationship shown in Diagram 1, it is known that a rise in the absolute level of the forward rate must reduce trader demand for forward cover even if the forward discount is unreduced. Therefore, the Dtrad curve in Diagram 2 which refers to successively higher spot rates (and, hence, for any given forward discount, to higher forward rates) must be shifted increasingly to the left.

Spot rates may rise when British interest rates are increased for the purpose of attracting foreign funds. Any inflow of funds would tend to cause appreciation of the spot pound, and the Dtrad curve would therefore shift to the left. But that leftward shift must reduce the possibilities for transfers of covered funds to the United Kingdom. Even if the Dtrad and Sarb curves were very elastic—so that scope seemed to exist for large transfers of covered funds—the leftward shift of the Dtrad curve might prevent significant transfers from occurring. That result is not the most frequent one, however. As was seen in 1960 when the official reserves of the United Kingdom increased (and decreased) by large amounts while the spot pound was held very close to $2.81, the possibilities for such counteracting movements of the spot rate may be limited.

Quantitative Importance

Dollar-sterling trade

A rough idea of the possible amount of the short-term capital flows evoked by the opportunities for covered interest arbitrage can be derived from the amount of forward exchange that traders would normally be using and the variation in this amount that would be caused by a small change in the forward rate (spot rate constant). We may assume that there is general confidence that the exchange parity and limits will remain fixed for the next three months. If in these conditions forward sterling were quoted at its lower limit, $2.78, all importers having sterling payments to make in three months would buy corresponding amounts of forward sterling, and no exporters would sell forward. At the upper limit, $2.82, no importers would buy forward, but all exporters would sell forward pounds equivalent to the value of the receipts that they expect over the next three months.

The preceding implies that a movement in the rate for the forward pound from $2.82 to $2.78 would raise traders’ net demand for forward sterling by the equivalent of three months’ exports plus three months’ imports—i.e., by approximately the value of one half of a year’s exports. This range could not be fully exploited by interest arbitragers because, as described above, a ⅓ per cent change in the rate—one fourth of the distance from $2.82 to $2.78—would cancel out the advantages of a 1⅓ per cent interest rate differential. For purposes of discussion, it may therefore be taken that traders’ adjustments would permit a covered arbitrage movement no greater than one eighth of a year’s exports (one fourth of one half of a year’s exports).

The opportunities for transfer of covered funds would be larger than this if the forward rate were initially not much more than ⅓ per cent above its lower limit of $2.78, for, as the actions of arbitragers pushed the forward pound close to $2.78, an occasional participant in the forward market—the speculator on small movements in exchange rates—would find it increasingly worthwhile to buy forward sterling. (At the worst, the spot rate would also be at $2.78 when the speculator’s forward contract matured, in which case a very small loss would be incurred; but a higher spot rate could be expected, if it had not already been at $2.78 for an abnormally long time, and some exchange profit would be foreseen.) At the extreme, a forward pound rate of $2.78 would connote an infinitely elastic D curve, and there could be no further depreciation of the forward pound to limit any transfers of covered funds to London that are initiated by a rise in U.K. interest rates.5

Because the importance of the possibilities for covered arbitrage can be demonstrated without reference to the special case of a forward pound close to $2.78 at a time when exchange parities are not under suspicion, the previous finding that arbitrage movements are limited in practice to one eighth of a year’s exports will be retained for purposes of discussion. (Of course, the $2.78 rate is not an unreasonable assumption if interest rates in the United Kingdom are already substantially above those in the United States when a further increase in U.K. rates is being considered, since that excess would imply the existence of a substantial forward discount on sterling.)

Non-sterling trade

It is clear that this fraction of one eighth can be safely applied to all commercial transactions directly between the two countries concerned. But bilateral trade between money-market countries is usually a small fraction of their total trade. Only one sixth of total U.S. import and export trade has been with the United Kingdom (and the rest of the sterling area). It is important, therefore, to determine how much of arbitragers’ desired forward transactions may be absorbed by trade with third countries. When U.K. interest rates rise and the forward pound is made to depreciate by, say, 1 per cent, consistency requires that the sum of the forward pound’s depreciation in terms of francs and the forward franc’s depreciation in terms of dollars total the same 1 per cent. In a first approximation, each will depreciate by ½ per cent if the slopes of the two bilateral Dtrad curves (£/F and F/$) are equal. In that case, the amount of forward cover made available for arbitragers through this trilateral channel is that associated with a ½ per cent change in forward rates, rather than a 1 per cent change: those conducting the trade between the United States and France will buy only the extra amount of forward francs which the ½ per cent depreciation of the forward franc relative to the dollar induces them to buy, and those conducting trade between France and the United Kingdom will buy only that extra amount of forward pounds which is made desirable by the ½ per cent depreciation of the pound relative to the franc. (Since the two Dtrad curves were assumed to have equal slopes, it follows that arbitragers desiring to sell pounds forward for forward dollars are enabled to sell approximately the same gold-value amounts of forward pounds in exchange for forward francs as they sell forward francs in exchange for the forward dollars they seek.) If, to simplify further, the slope of the U.S.-U.K. Dtrad curve were the same as the other two, it would follow that half as much cover for arbitrage transfers would be obtained through the indirect, trilateral channel as through the direct channel of U.S.-U.K. trade. (Only one third as much could be obtained through quadrilateral channels if these were used.) A full description of the multilateral mechanism would go beyond the scope of this paper.6

Where depreciations of the forward exchange values of several currencies are involved, the probability is created that some forward currency will be pushed close to its lower gold point. In that situation, the possibilities for arbitrage provided by a dollar of trilateral trade would be almost as large as those created per dollar of direct U.K.-U.S. trade. At the extreme, if, before the rise in U.K. interest rates, the forward franc was already at its lower limit in terms of the dollar, the speculative demand for forward exchange (described above as infinitely elastic when the forward rate was at the lower gold point) would prevent any further depreciation of the forward rate, and all the assumed 1 per cent forward depreciation would be concentrated in just one exchange market—on the £/F rate. U.S. trade with France would therefore provide just as much cover for funds placed in London as U.S. trade with the United Kingdom.

Because of this consideration, it will be assumed for illustration that each dollar of U.S. trade with non-sterling countries can provide cover for one half to three fourths as much arbitrage as does a dollar of U.S. trade directly with the United Kingdom. If it is assumed that the average of U.S. commercial export and import trade with the sterling area is about $3 billion and the corresponding figure for trade with the rest of the world is, perhaps, $15 billion, then the $18 billion total of U.S. commercial exports is equivalent, for present purposes, to $10½-14¼ billion of exports to the sterling area. On the assumption that the arbitrage movement can be as much as one eighth of such exports when short-term interest rates in the United Kingdom rise 1⅓ percentage points above U.S. rates, it follows that scope exists for the transfer within a few months of $1.3-1.8 billion of covered funds from the United States to the United Kingdom.

The significance of this amount of capital outflow may be increased by the presence of an accompanying outflow of uncovered medium-term funds. If there is confidence in the spot exchange parities, such outflows could occur, for an exchange loss of even 1 per cent on uncovered arbitrage funds would no more than neutralize the advantage of a 1 percentage point higher interest yield on one-year foreign securities.

Measures for Restraining Interest Arbitrage Transfers

Since 1958, international movements of short-term funds searching for maximum interest yields have once more become a problem for countries with active money markets, and the question arises whether drastic measures will be needed to limit capital transfers. The fact that very large proportions of the capital transfers are dependent on forward cover suggests the possibility of limiting these capital movements by measures much less drastic than either changes in domestic interest rates not required by internal conditions, or exchange control.

Central bank participation in the forward market

A generation ago, Keynes proposed official intervention in the forward market in order to adjust interest rates in accord with internal requirements, free from the counteracting influence of covered interest arbitrage. For example, in conditions like those represented in Diagram 2, the United States could have prevented the outflow of covered funds responding to higher short-term interest rates abroad by selling enough forward sterling to force it to a ⅓ per cent discount below the spot rate. This would have meant the sale of forward sterling equal to the amount that would otherwise have been sold by arbitragers (od in Diagram 2) plus an additional amount necessary to satisfy the enlargement of traders’ demand for forward sterling which the cheapened price would elicit (de).7

If the country thus intervening in the forward market had a strong exchange position or expected its position to strengthen, the incurring of such large forward exchange liabilities by the central bank would create no problem. If, however, the main reason for resisting an outflow of capital was that it might endanger the country’s exchange position, the advantages of such intervention are more doubtful. By restraining arbitragers from buying the foreign currency spot, the intervention does, it is true, conserve official exchange reserves (od in Diagram 2), but it does so at the expense of raising official short-term foreign exchange liabilities by a larger amount (od + de).8

The debate on the merits of prolonged intervention in the forward market will not be resumed here.9 It is appropriate at this point only to show how the picture is altered by the new factor of traders’ enhanced sensitivity to forward rate movements. The foregoing analysis suggests that the potential covered interest arbitrage movements are much larger than has been commonly supposed, so that the need for deterrents is greater; but where the adequacy of reserves is the motive for intervention, the cost of the deterrent is also greater than has been hitherto believed. If the Dtrad curve of Diagram 2 were the much steeper one previously supposed to exist, the distance de would be much smaller, i.e., the excess of the immediate rise in official short-term (forward) liabilities over the saving in official exchange holdings would be smaller. Insofar as the weakening of the official “net” foreign exchange position is considered as weighing against official intervention in the forward market, then the foregoing demonstration of increased flexibility in traders’ use of the market weakens the case for official intervention. In one sense, this demonstration implies a reduced need for intervention. This is so where the motive for intervening is fear that wide movements in the forward rate will elicit destabilizing speculation on the exchanges. The flatter Dtrad curve implies a narrower range of variation for the forward rate and hence less risk of destabilizing specualtion.

Aside from their effects on the exchange reserves, covered arbitrage movements may be deemed undesirable because of their effects on internal money markets and on money supply conditions. This should not be an important problem for the United Kingdom, the United States, or countries that have equivalent means of “sterilizing” gold inflows and outflows by changing the supply of Treasury bills, etc. In the money markets of other countries, however, short-term capital movements may be disruptive. For such countries, the demonstration that these movements can be larger than previously supposed strengthens the case for official intervention.

Widening the spread between upper and lower intervention points

A widening of the “spread” between the gold points has sometimes been proposed as a means of discouraging speculative capital movements, if doubts develop about stability of the exchange rate. This device also has advantages with respect to the nonspeculative movements of covered arbitrage funds. The means by which the widened spread reduces the scope for arbitrage transfers that reflect changes in interest rate differentials is illustrated by Diagram 1. The maximum change in traders’ net use of forward cover occurs when the price of forward sterling changes by the full distance between the lower and upper gold points, $2.78 and $2.82, respectively. If the range between these were doubled (the lower and upper points being $2.76 and $2.84), the same change in traders’ net use of cover would develop only over twice as great a movement in the forward rate. Consequently, the slope of the traders’ net demand curve would also be doubled, and a given change in the forward discount would provide half as much opportunity for covered interest arbitrage. If the slope of the Dtrad curve of Diagram 2 is doubled, but the zero point (c) unchanged, then (as a first approximation) the capital movement will be cut almost in half: the steeper Dtrad curve will intersect the Sarb curve a little to the right of ⅓ od. If the capital movement had already taken place, widening the spread would cause a return flow to the United States of almost ½ od.10 (This analysis may require some qualification to allow for the effect, noted earlier, of associated movements of the current spot rate.)

Widening the spread between de facto intervention points

Permitting the spot exchange rate to rise close to its present upper limit of $2.82 should greatly reduce the possibilities for covered arbitrage in the United Kingdom. As described above in the interpretation of the diagrams, the higher the absolute level of the forward pound that is associated with any given forward discount, the smaller is traders’ demand for forward pounds. At a forward rate as high as $2.81, the proximity to the upper gold point would become a matter of interest even to those traders who rely chiefly on the size of the forward discount when deciding on how much forward cover to use. They might find the forward pound cheap at a 1 cent discount below the spot pound; but the spot pound itself would tend to seem abnormally high; and, when measured against a more likely figure for the spot pound three months hence, the forward price of $2.81 would tend to seem to be no discount at all. Therefore, when the spot pound had risen to $2.82, the Dtrad curve for a forward rate of $2.81 would probably be closer to the negative value of Diagram 1 than to the positive value shown in Diagram 2 for the equivalent discount (one U.S. cent, or 1⅓ per cent, annual interest-rate basis). At the least, it can be assumed that trader demand for forward sterling would be very small.

Thus it is probable that permitting the pound to appreciate close to its upper gold point ($2.82) would create a major deterrent to covered short-term capital movements. This procedure would have the advantage of avoiding the problems of a widened official spread, and would probably also be a greater deterrent to capital movements.

De facto, the United Kingdom has intervened at a spot rate of about $2.81, expanding and contracting the official gold and dollar reserves by large amounts while the rate was at that level. (Under severe pressure, it has permitted the pound to drop to as low a rate as $2.79.) This behavior suggests a desire to keep the spot rate within one cent of par where possible, and hence a reluctance to widen either the de facto or the official intervention points. If covered interest arbitrage movements should constitute a serious problem, the merits of a widened de facto range of variation within the existing gold points might be found to outweigh its disadvantages.

Différences entre les taux d’intérêt, mécanisme des opérations de change à terme, et champ d’action des mouvements de capitaux à court terme


En période de confiance dans les parités du change, les mouvements de capitaux à court terme en quête d’un taux d’intérêt plus élevé dépendent habituellement de la possibilité de vendre à terme la devise acquise; dans le cas de placements à trois mois, une dépréciation de cette monnaie même aussi minime que 1/3 pour-cent suffirait à éliminer le bénéfice de l’obtention d’un taux d’intérêt plus élevé de 1-1/3 points que le taux local. Mais on avance généralement la thèse que les importateurs n’achéteront guère plus de devises à terme même en réponse á une réduction de prix de ½ pour-cent; il en résulterait que très peu d’arbitrage de “couverture” pourrait alors se produire. Cette conclusion n’est plus valable. Lorsque les parités en cours jouissent de la pleine confiance quant à l’avenir immédiat, l’importateur prudent qui, pour se couvrir contre tous ses risques de change, fait appel à l’achat du change à terme si le taux à terme de la monnaie étrangère s’est déprécié au point de sortie de l’or, ne le fera plus lorsque ce taux se sera apprécié au point d’entrée de l’or. Par conséquent, avec quelques réserves au cas où des changements s’opéreraient dans le taux au comptant, l’occasion peut donc se présenter de transférer par exemple un à deux milliards de dollars d’avoirs à court terme de New York à Londres au cours d’une période de plusieurs mois, si les taux d’intérêt au Royaume-Uni s’élèvent de 1-1/3 points. (Ceci dans l’hypothèse où chaque dollar du commerce avec les pays tiers fournit la moitié des possibilités de couverture qu’offre le commerce direct entre le Royaume-Uni et les Etats-Unis).

La thèse en faveur de ventes officielles de devises à terme afin de décourager les sorties de capitaux pour arbitrage, est done renforcée. Cependant, une plus grande sensibilité des importateurs au prix des devises à terme oblige à des ventes officielles plus considérables pour arrêter la sortie de capitaux pour un montant donné; ainsi les opérations à terme réduisent la position des avoirs officiels nets en devises bien plus qu’on ne le croit habituellement. D’autres moyens de limiter les transferts d’arbitrage sont d’augmenter l’écart entre les limites supérieure et inférieure du point d’or (ce qui accroît la modification du taux à terme nécessaire pour produire un changement donné dans la demande des importateurs en devises à terme), et permettre au taux de change au comptant du pays importateur de capital de s’apprécier au point d’entrée de l’or.

Las diferencias en los tipos de interés, el mecanismo de las divisas a término, y el alcance de los movimientos de capital a corto plazo


En épocas en que se tiene confianza en las paridades cambiarías, los movimientos de capital a corto plazo en busca de tipos de interés más elevados suelen depender de las posibilidades de vender a término la moneda adquirida; cuando se trata de inversiones a 3 meses de plazo, aun una depreciación de esa moneda que fuese tan sólo de 1/3 del 1 por ciento vendría a contrarrestar la ventaja de percibir una tasa de interés superior en 1 y 1/3 puntos. Pero se ha aducido generalmente que ante una reducción del ½ por ciento del precio los importadores aumentarán sólo muy ligeramente sus compras de divisas a término, y que, por tanto, resulta sumamente limitado el arbitraje con cobertura que puede ocurrir. Esa conclusión ya no es valedera. En los casos en que se confía plenamente en que las paridades existentes habrán de prevalecer durante el futuro cercano, el importador precavido, que en los momentos en que el tipo cambiario de las divisas a término se encuentra depreciado hasta el punto de oro más bajo utiliza las divisas a término para cubrirse contra todo riesgo en el futuro, dejará de emplearlas en absoluto cuando su valor se eleve hasta el punto de oro más alto. De ahí que, con cierta modificación en aquellos casos en que haya alguna alteración del tipo de cambio al contado, existen, efectivamente, posibilidades como, por ejemplo, de trasladar de US$1.000 millones a US$2.000 millones en saldos a corto plazo de Nueva York a Londres durante un lapso de varios meses, si los tipos de interés en el Reino Unido suben 1 y 1/3 puntos. (Ello en la hipótesis de que cada dólar del comercio con terceros países ofrezca la mitad de las posibilidades de cobertura que proporciona el comercio directo entre el Reino Unido y Estados Unidos.)

Así pues, queda reforzada la tesis en favor de las ventas oficiales de divisas extranjeras a término como medida para desalentar la salida de capital para el arbitraje. Sin embargo, la mayor susceptibilidad de parte de los importadores respecto a los precios de las divisas a término también exige mayores ventas oficiales para impedir una salida dada de capital, de manera que las operaciones a término reducen la posición neta de los haberes oficiales en divisas extranjeras en un grado muy superior al que suele suponerse. Otras medidas que sirven para limitar las transferencias para fines de arbitraje son el aumento de la diferencia que media entre el punto de oro más alto y el más bajo (con lo cual se aumenta la variación del tipo de cambio a término que se necesite para producir una modificación dada de la demanda de divisas a término por parte de los importadores), y permitir que el tipo de cambio al contado del país que recibe las transferencias suba hasta alcanzar su punto de oro más alto.


Mr. White, economist in the Finance Division, received his undergraduate and graduate training at Harvard University. He has contributed articles to a number of economic journals.


For a thorough discussion of many aspects of the forward exchange market not covered here, see S. C. Tsiang, “The Theory of Forward Exchange and Effects of Government Intervention on the Forward Exchange Market,” Staff Papers, Vol. VII (1959-60), pp. 75-106.


Definitions of terms used in this discussion:

Forward exchange: A contract to buy (sell) foreign exchange at some stated future date, the exchange rate used being agreed to at the time the contract is made. (Contracts are commonly made for periods of up to six months in advance of the exchange transaction.)

Forward cover: An exchange contract used to offset the exchange rate risk incurred in the holding of assets denominated in a foreign currency or in an obligation to make (receive) a payment in foreign currency.

Spot exchange rate: The rate of exchange between currencies—the exchange rate in which transactions that are to be immediately carried out are arranged.

Forward premium on the pound: The percentage excess of the price of the pound for future delivery over the spot exchange price of the pound in terms of some other currency. (When the forward pound is at a discount, the pound’s price in the forward market is cheaper than its price in the spot market.)

To aid understanding, the discussion of the forward exchange mechanism is being expressed in this paper in terms of sterling/dollar transactions. However, it is not implied that any of the situations described is especially characteristic of those two currencies.


“The potential benefit to the dollar, however, cannot be measured simply by the relative change in interest rates. Since very few short-term funds these days cross national boundaries without being covered against the risk of an alteration in the exchange rate before they are repatriated, the cost of such forward cover must also be taken into account. Indeed, when there are no pressing fears of depreciation, the forward rate will normally adjust itself to the differential in money rates between the two centres, thus eliminating the incentive to transfer funds. … [this] calls into question whether the mere adjustment of interest differentials can be relied upon to exert any significant effect on the flow of short-term funds unless it is flanked by an active policy of influencing forward exchange rates as well. In short, even if European money rates do not rise at all, the rise in U.S. rates may have no real impact on the flow of funds to Europe unless the authorities intervene in the forward market—as they did successfully in 1961.” From “America Tackles Its Deficit,” The Banker, Vol. CXIII (August 1963), p. 525.


Paul Einzig has said that some of the traders dealing in items with wide profit margins can afford to take the risk of going uncovered, especially since it keeps alive the chance of an exchange profit. But he apparently is not reporting anything like the systematic, strong reaction of traders to changes in the cost of forward cover which is implied by the reasoning offered above. Whereas Einzig says that traders in staple commodities operate on profit margins that are too narrow to permit the running of such risks (A Dynamic Theory of Forward Exchange, London, 1961, p. 65), the reasoning above implies that higher profits will be earned—on the average, at least—by using less exchange rate insurance, the more its cost rises toward the amount of the maximum exchange risk. Even if ownership capital would otherwise be inadequate, these extra profits should provide the intelligent commodity trader with a self-insurance fund adequate for survival of any plausible succession of exchange losses of, say, 1 per cent.

Somewhat stronger belief that traders are sensitive to the cost of forward cover is indicated by the testimony which the Governor of the Netherlands central bank gave to the Radcliffe Committee in late 1958 (Committee on the Working of the Monetary System, Minutes of Evidence, London, 1960, p. 816). However, no similar view could be found anywhere else in the Committee’s evidence, memoranda, or report.


Under these conditions the scope for arbitrage could be further enlarged by arbitragers’ forgoing forward cover. Those who are as willing as the traders to trust the exchange parities would see no advantage in selling the pound forward at a price little above its lower limit of $2.78. (See John Maynard Keynes, Treatise on Money, II, London, 1930, pp. 323–26.)

This and the speculative factor have been offered as explanations of the coexistence after mid-1960 of large arbitrage transfers and a yield on U.K. Treasury bills (net of the cost of cover) that remained 1 percentage point higher than the yield on U.S. bills (John H. Auten, “Foreign Exchange Rates and Interest-Rate Differentials,” The Journal of Finance, Vol. XVIII, March 1963, pp. 17-18). But because that explanation must assume substantial speculative purchases of forward sterling when the price falls only 0.6 cent below $2.80, and when a deepening U.S. recession could have promised a weaker spot pound, the trader reactions proposed in the present study seem to be a better explanation.


Some of the relevant factors are the following: The slope of the other bilateral Dtrad curves may be raised above that of the U.K.-U.S. curve because of less well organized forward exchange markets; a 3 per cent permitted range of variation for the spot exchange rates between European currencies (more, where Switzerland is involved) in contrast to the 1½ per cent range for rates against the dollar (see discussion of widening the spread between the gold points below); and less confidence in the maintenance of the exchange parities of such countries.

The opportunity for covered transfer from the United States to the United Kingdom is further reduced where there are arbitrage funds in France that also will be attracted to the United Kingdom. If the associated sales of forward pounds in exchange for francs proved sufficient to account for a ⅓ per cent depreciation of the forward £/F rate, only ¼ per cent more would have been left for the use of the arbitragers who wanted to leave New York; and, as above, this would have to be divided between the two bilateral forward markets. Hence, the trilateral channel would provide cover for only a little over one fourth as much arbitrage as the 1 per cent depreciation of the forward £/$ rate would provide through the direct, bilateral channel.

A factor which may increase the scope for trilateral arbitrage is central bank purchases of home forward currency to limit the severity of its depreciation.


The cheapening of the forward price of pounds may cause some diversion from the spot to the forward market of speculation that would occur in any case; but this can be disregarded because it would merely substitute a rise in short-term official liabilities for a fall in official reserves. If the cheapening goes far enough to bring the pound close to its lower gold point, it will also cause the speculative purchases of forward pounds described earlier, and purchases of that kind should be taken into consideration.


It should be noted that the creation of extra forward contracts with traders merely formalizes a part of the authorities’ existing obligation to provide importers with foreign exchange in three months’ time; importers merely arrange now to purchase foreign exchange in three months’ time that they would otherwise have had to purchase in three months without prearrangement. From this consideration, the additional short-term liabilities can be considered as neutralizing a much smaller amount of foreign exchange assets.


Two new viewpoints on that question may be of interest. Einzig argues that prolonged official efforts to hold down the premium on forward foreign exchange when the home currency position is weak are undesirable because they could require the central bank to assume a volume of forward liabilities larger than its gold and exchange holdings. That excess would be of no concern (psychological factors aside) insofar as the buyers of forward exchange lacked surplus liquid assets and therefore would be unable to hold abroad the exchange acquired when the contract matured. (If they did hold liquid funds, they would presumably acquire spot exchange if forward exchange remained expensive.) However, he finds that foreign-owned domestic companies are an important special case; they would not buy spot exchange to protect themselves against a possible devaluation but would buy large amounts of forward exchange, provided that the premium paid was not too high. They could do so, even though illiquid, because the companies’ inventories and other assets could be liquidated if it became necessary to provide local currency to carry through the forward contract. (See Paul Einzig, “Some Recent Developments in Official Forward Exchange Operations,” The Economic Journal, Vol. LXXIII, June 1963, pp. 248-50, 252-53.)

But the only condition under which they would want to restrict their domestic operations to gain funds for financing the acquisition of foreign balances would be when the central bank was forced to stop holding down the premium on forward exchange at a moment when devaluation seemed likely. And for even that situation to be relevant, it must be assumed that the foreign-owned firms would not have become interested in holding spot foreign exchange at the expense of their regular business operations except for having been first drawn into it by the possibility of speculating cheaply in the forward market.

The case for prolonged official sales of forward exchange seems likely to survive this criticism.

Another criticism of prolonged official intervention in the forward market (Jerome L. Stein, “The Rationality of Official Intervention in the Forward Exchange Market,” The Quarterly Journal of Economics, Vol. LXXVII, May 1963, pp. 312-16) can be interpreted as merely a warning to the confused central bank that would want to attract short-term capital by selling the home currency forward, when the (annual rate of) forward discount on the home currency was already smaller than the excess interest yield obtainable on domestic Treasury bills; such sales would, of course, increase the discount on the home currency and thereby discourage the movement of short-term funds into the country. Bent Hansen objected to that form of prolonged official participation which would seek successive additions to the stock of arbitrage funds held in a low-interest-rate country which was experiencing persisting current-account deficits. Once the domestic arbitrage funds held abroad and the easily attractable foreign funds were attracted, the remaining supply would be inelastic, and further transfers could be secured only by very large additional official sales of forward exchange (Bent Hansen, “Interest and Foreign Exchange Policy,” Skandinaviska Banken Quarterly Review, Vol. 39, October 1958, p. 121). It is possible that the recent rapid growth of the stock of arbitrageable funds has greatly reduced the importance of this objection.


The zero point could move in either direction. It is actually the two curves underlying the Dtrad curve, Dm and Sx, which undergo the doubling of slopes. These curves can be conceived of as remaining imchanged at a point midway between the gold points, with the steepening of slopes taking the form of a rotation around each midpoint. If the two curves intersect at that level (Dtrad = zero at $2.80), the zero point on Dtrad does not shift. But if the intersection point, and c, are above $2.80 (as when imports are larger than exports), widening the spread will raise the intersection point and c; that means that the part of the Dtrad curve lying above $2.80 is shifted to the right. If the forward rate is above $2.80, the widening of the spread causes funds to move from New York to London; in the more likely case of a forward rate not much below $2.80, it would cause only a small movement to New York.