FOREIGN-EXCHANGE HEDGING AND THE INTEREST-RATE DEFENSE

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 re sult if a large proportion of investors' foreign exchange exposure is dynamically hedged. This paper describes the trading operations involv ed in implementing dynamic hedges and the impact of these operations o n central bank policy. The success of an interest rate defense hinges on the size and timing of the funding operations of those who are bein g squeezed relative to those engaged in dynamic hedging.