Forward exchange market intervention is not necessarily neutral

Abstract

traditional paradigm of the forward exchange market assumes that speculators in the forward and spot exchange markets are two analytically distinct classes of wealth holders. The reason for this dichotomy is that spot speculation requires the ownership of funds while forward exchange speculation involves only a contingent future liability. When spot speculators wish to lever their net worth they have to enter the money market to borrow and have to pay the borrowing rate of interest. Forward exchange speculators, on the other hand, can readily enter contracts and have to provide spot funds representing only a fraction of the face value of the contract. The margin requirement in many forward markets is 10 per cent, but for some large speculators it may average less. As a result of these institutional differences the costs and risks of speculating in spot and forward markets are vastly different and the leverage available to forward speculators has made them the target of special analysis. The dichotomy between spot and forward exchange speculators has led to the convenient assumption that the two markets are separate and expected profit in one have no influence on activity in the other. This assumption limits the usefulness of all analysis undertaken with the traditional forward exchange model especially since spot rates are assumed also to be independent of the level of covered arbitrage. A second aspect of the traditional forward exchange paradigm has been the assumption that expectations of speculators are independent of forward exchange policy and that the probability of devaluation is not affected by the forward policy itself. While my paper1 initially developed some propositions within this simple model of the forward exchange market, the main objective of the study was to extend the traditional paradigm in two ways. First, I