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Foreign Exchange Hedging and the Interest Rate Defense

Peter Garber and Michael G. Spencer

IMF Staff Papers, 1995, vol. 42, issue 3, 490-516

Abstract: In the endgame of a fixed exchange rate regime, increases in interest rates to defend the currency may lead to an apparently perverse market response: further downward pressure on the exchange rate. This may result if a large proportion of investors' foreign exchange exposure is dynamically hedged. This paper describes the trading operations involved in implementing dynamic hedges and the impact of these operations on central bank policy. The success of an interest rate defense hinges on the size and timing of the funding operations of those who are being squeezed relative to those engaged in dynamic hedging.

Date: 1995
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