INTERNATIONAL CAPITAL: The Role of Derivatives in Crisis-Driven Capital Outflows

Posted by Connie R. Aponte on August 3, 2014 in INTERNATIONAL CAPITAL |

This section will show how forward contracts transmit an impending attack on a central bank’s reserves through foreign exchange swap and spot exchange markets.16 Next, using the examples developed earlier from the Mexican case, it will show how the existence of these products operated to determine the dynamics of exchange markets leading into the currency crisis of December 1994, to determine the magnitude of the final attack, and to drive the foreign exchange market turbulence in the months after the attack.

The Mechanics of Speculative Attack

This section covers the mechanics of exchange market operations in speculative attacks.

It shows how transactions in forward exchange work their way through the banking system and how they are financed. It discusses in particular the effect of reducing credit to speculators, either through interest rate increases or, more directly, through controls.

Speculators generally attack a weak currency by selling the currency through forward contracts to a bank at relatively long maturities, e.g. thirty days. Whether a customer speculates through a short sale or hedges a long position, the international banking system handles a forward sale of a currency in the same way. As standard practice to balance the long position in the weak currency that this transaction initiates, the counter party bank will immediately sell the weak currency spot for the conventional two day settlement.

Although its currency position is then balanced, the bank still has a maturity mismatch in both currencies: it can borrow the weak currency overnight to cover settlement of the spot sale, but it will receive the currency in thirty -days through the forward contract. It faces the opposite maturity mismatch with its strong currency position. To close this maturity mismatch, a bank typically will transact a foreign exchange swap. These are customary wholesale operations executed by banks writing forward contracts to customers, in both normal periods and speculative episodes.

Table 5 presents a concrete example of such a forward transaction. In this example, the weak currency is the baht and the strong currency is the dollar. Suppose that the forward and spot exchange rates between the dollar and the baht are 25 baht per US dollar. In the first step, a customer sells 2500 baht forward for $100 to a bank. This is an off-balance sheet item for the bank, but it has payments implications like any on-balance-sheet transaction.

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