Central Bank Intervention With Limited Arbitrage
Christopher J. Neely
Federal Reserve Bank of St. Louis - Research Division
Paul A. Weller
University of Iowa - Department of Finance
FRB of St. Louis Working Paper No. 2006-033B
Shleifer and Vishny (1997) pointed out some of the practical and theoretical problems associated with assuming that rational speculation would quickly drive asset prices back to long-run equilibrium. In particular, they showed that the possibility that asset price disequilibrium would worsen, before being corrected, tends to limit rational speculators. Uniquely, Shleifer and Vishny (1997) showed that "performance-based asset management" would tend to reduce speculation when it is needed most, when asset prices are furthest from equilibrium. We analyze a generalized Shleifer and Vishny (1997) model for central bank intervention. We show that increasing availability of arbitrage capital has a pronounced effect on the dynamic intervention strategy of the central bank. Intervention is reduced during periods of moderate misalignment and amplified at times of extreme misalignment. This pattern is consistent with empirical observation.
Number of Pages in PDF File: 27
Keywords: Intervention, foreign exchange, limits to arbitrage, arbitrage, noise trader
JEL Classification: F3, F31, E58working papers series
Date posted: May 16, 2006
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