In this paper, we examine the impact of dynamic hedging strategies on foreign exchange markets in times of crisis, where even foreign exchange markets can become illiquid. While we attach some importance to the well-known inability of these strategies to function well for the hedger in the event of exchange rate discontinuity or increased volatility, we are primarily concerned with the impact of hedging strategies on the effectiveness of the central bank`s conventional exchange rate defence. It is generally accepted that a central bank can defend an exchange rate if it is prepared to raise short-term interest rates to the point of putting pressure on speculators who are short in its currency. However, in the presence of dynamic hedges, the end of interest rate defence can lead to mechanistic sales of the national currency, which could overburden the central bank`s lines of credit to intervene in the foreign exchange market before those who have been put under pressure by rising interest rates begin to buy. That is why we focus mainly on the behaviour of central banks and the market in the crucial last moments of a fixed exchange rate, the limit point towards which the collapsing system converges. How important will the dynamic protective response be? Chart 8 shows how dynamic hedging programs are reacting in the last few days of an administered or fixed exchange rate regime. In the days leading up to the collapse of a band regime, the gradual depreciation of the spot exchange rate will have a significant impact on the hedging rate, which will require a gradual increase in effort in the short term. However, in the final hours or minutes of such a regime or an absolutely fixed exchange rate, the use of large interest rate increases to defend the fixed exchange rate can lead to an increase in hedging of a similar magnitude. It is important that, in a systemic exchange rate regime or a quasi-fixed system such as the KM exchange rate, the limit values for the nominal exchange rate become hot spots for speculation on the direction of exchange rate change. Not only will more investors begin to hedge their exposures as the risk of reorientation or change in parity increases, but the options that are written for clients will all tend to have similar exercise prices, so they will tend to react in the same way to changes in foreign interest rates. If the exchange rate falls to the lower limit – a natural value for the exercise price of the put option – the option delta becomes more sensitive to changes in the foreign interest rate (Figure 8). In the event of a currency crisis, a sharp defensive rise in the interest rate, which is intended to put pressure on speculators, will immediately trigger hedging programs to control sales of the weak currency. 31/ Experiments using actual interest rate data and historical volatility suggest that the sale triggered by dynamic hedging programs during an interest rate defence may be significant.

The existence of a large number of these programs on the market would jeopardize the use of a low currency`s interest rate defence – at a time when a central bank is raising interest rates, it could face an avalanche of sales of its currency rather than the tight shorts it expected.

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