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Central bank intervention with limited arbitrage

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  • Christopher J. Neely
  • Paul A. Weller

Abstract

Shleifer and Vishny (1997) 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, Shleifer and Vishny (1997) 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 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.

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Bibliographic Info

Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2006-033.

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Date of creation: 2007
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Publication status: Published in International Journal of Finance and Economics, April 2007, 12(2), pp. 249-60
Handle: RePEc:fip:fedlwp:2006-033

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Cited by:
  1. Christopher J. Neely, 2007. "Central bank authorities’ beliefs about foreign exchange intervention," Working Papers 2006-045, Federal Reserve Bank of St. Louis.
  2. Reitz, Stefan & Taylor, Mark P., 2006. "The coordination channel of foreign exchange intervention: a nonlinear microstructural analysis," Discussion Paper Series 1: Economic Studies 2006,08, Deutsche Bundesbank, Research Centre.

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