Central banks typically raise domestic interest rates to attract capital during times of crisis. This 'interest rate defence' is used by most central banks to defend fixed exchange rates against speculative attacks. In Discussion Paper No. 1059, Richard Lyons and Research Fellow Andrew Rose use intra-day data from times of crisis in the European Monetary System for the lira and the French franc to explain the forward exchange bias.

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, the authors find that this prediction is borne out.

Explaining Forward Exchange Bias .... Intra-day
Richard K Lyons and Andrew K Rose

Discussion Paper No. 1059, November 1994 (IM)