DP1059 Explaining Forward Exchange Bias .... Intra-day

Author(s): Richard K Lyons, Andrew K Rose
Publication Date: November 1994
Keyword(s): Crises, Defence, Foreign Exchange, Interest Rate, Returns
JEL(s): F31, G15
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=1059

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.