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Central bank intervention with limited arbitrage

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Author Info

  • Christopher J. Neely

    (Research Department, Federal Reserve Bank of St. Louis, USA)

  • Paul A. Weller

    (Department of Finance, University of Iowa, USA)

Abstract

Shleifer and Vishny (SV) pointed out some of the practical and theoretical problems associated with assuming that rational risk-arbitrage 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, SV showed that 'performance-based asset management' would tend to reduce risk-arbitrage when it is needed most, when asset prices are furthest from equilibrium. We analyse a generalized SV 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. Copyright © 2007 John Wiley & Sons, Ltd.

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File URL: http://hdl.handle.net/10.1002/ijfe.328
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Bibliographic Info

Article provided by John Wiley & Sons, Ltd. in its journal International Journal of Finance & Economics.

Volume (Year): 12 (2007)
Issue (Month): 2 ()
Pages: 249-260

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Handle: RePEc:ijf:ijfiec:v:12:y:2007:i:2:p:249-260

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Web page: http://www.interscience.wiley.com/jpages/1076-9307/

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References

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Citations

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Cited by:
  1. Neely, Christopher J., 2008. "Central bank authorities' beliefs about foreign exchange intervention," Journal of International Money and Finance, Elsevier, vol. 27(1), pages 1-25, February.
  2. Reitz, Stefan & Taylor, Mark P., 2008. "The coordination channel of foreign exchange intervention: A nonlinear microstructural analysis," European Economic Review, Elsevier, vol. 52(1), pages 55-76, January.

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