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Central bank intervention with limited arbitrage

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Christopher J. Neely
Paul A. Weller

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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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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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  30. Rapach, David E. & Wohar, Mark E., 2002. "Testing the monetary model of exchange rate determination: new evidence from a century of data," Journal of International Economics, Elsevier, vol. 58(2), pages 359-385, December. [Downloadable!] (restricted)
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Christopher J. Neely, 2007. "Central bank authorities’ beliefs about foreign exchange intervention," Working Papers 2006-045, Federal Reserve Bank of St. Louis. [Downloadable!]
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