CENTRAL BANKS' INTERVENTION IN FOREIGN EXCHANGE MARKETS -1

Most of the discussions in this assume that the goal of the funds manager is to run a profitable operation. subject to risk constraints. However, there is a large forex market participant whose goals are different. This participant is the central bank.

The objective of the central bank of a country is to achieve the goals that economic policy and international arrangements dictate. Making a profit is not an objective of central banks. How Not to Do It. To understand the impact that unilateral action by the central bank, or any other market participant, can have on the financial markets, let's look at the market situation as illustrated in Exhibit 8.16. Let's assume that the monetary authorities of some country have decided to create a forward exchange market for their currency against the dollar. They have a feeling that the dollar is relatively weak; therefore, they conclude that the dollar should be selling at a discount against the local currency. After some discussion, a consensus emerges that the central bank should enter the market by offering dollars against the local currency (LC) at LC3.96/$ for three-month delivery. Since the spot rate is LC4.00/$, the offered forward rate represents a discount of 4 percent per annum on the dollar against the local currency. What will be the reaction of the other market participants?

It is clear that the discount of 4 percent on the dollar against the local currency is out of line with the interest differential of 2 percent. The central bank has provided an incentive for the forex trading market to engage in covered interest arbitrage. The discount on the dollar is more than the interest differential in favor of this currency. The incentive is to convert funds spot from dollars into local currency and cover forward. The relevant rates are the following:

Borrow dollars 7% Swap dollars into local currency (sell dollars spot; purchase three-month dollars at a discount)-4 Net cost to generate fully covered local currency 3%. The local currency generated in the spot part of the swap transaction is now available to be invested at 5 percent, that is, a net profit of 2 percent. With a large number of market participants taking advantage of the situation, the country sees its financial markets flooded with funds.

Realizing that a discount of 4 percent per annum on the dollar may be too much, the central bank decides to change the quoted three-month forward rate to LC3.99/$. This implies a discount of 1 percent on the dollar against the local currency. Again, the central bank has set a forward rate which is out of line with the interest differential between the dollar and the local currency. The forward discount on the dollar is less than the interest differential in favor of that currency. There is an incentive to move funds from local currency into dollars on a covered basis. The costs of obtaining covered dollars are: less than the interest differential in favor of that currency. There is an incentive to move funds from local currency into dollars on a covered basis. The costs of obtaining covered dollars are:

To borrow local currency 5% To swap local currency into dollars (to sell local currency spot; to purchase it forward at a premium) +1 Net cost to generate fully covered dollars 6%. The dollars obtained in the spot transaction are now available to be invested at the market rate of 7 percent, providing a net profit of 1 percent. With a large number of market participants taking advantage of the situation that the central bank has created, the local financial markets will witness a substantial outflow of funds. Local funds are more valuable when invested via dollars than when invested in the local market.

Given that the objective of the central bank in this case was merely to provide a forward exchange market for its currency, the foreign capital flows produced by the central bank's intervention were undesirable in each instance. The central bank ignored the natural relationship between interest differentials and the forward exchange markets. In such a situation, large foreign capital flows in search of arbitrage profits are inevitable.