Explaining Forward Exchange Bias…Intraday

Abstract

Intraday 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 fixedrate crisis, since it suggests an immunity to the central bank's interest rate defense. In equilibrium, however, buyers of the vulnerable currency must be compensated on average with an intraday capital gain as long as no devaluation occurs. That is, currencies under attack should typically appreciate intraday. Using data on intraday exchange rate changes within the European Monetary System, we find this prediction is borne out. THIS ARTICLE EXAMINES IMPLICATIONS of the fact that interest rates are zero intraday.' In particular, we focus on the foreign exchange (FX) market, and ask whether trading strategies might be affected. The answer to this question is of greater import than might first appear. For example, in times of fixed-rate crisis, central banks typically employ an interest rate defense, raising domestic rates to attract a capital inflow and punish short-sellers. But, if dealers are immune to this defense-at least on an intraday basis-then perhaps the viability of fixed rate regimes is undermined. (Goldstein et al. (1993) provide an overview of how central banks defended their currencies during the 1992 currency crisis.) A simple example helps. With intraday interest rates of zero, a dealer can short a high interest rate currency in the morning, close her position in the afternoon, and never face an interest cost. If there is any likelihood of an intraday devaluation, this appears to be an attractive strategy, other things equal, since the dealer is immune to the interest cost of an overnight short position. Other things should not be equal in equilibrium, however. Buyers of the vulnerable currency must be compensated on average with an intraday capital gain, as long as no devaluation occurs. That is, devaluation risk is offset by systematic appreciation. Further, the greater the probability and size of the devaluation, the greater the implied appreciation. Thus, the absence of a role