Synthetic Foreign Exchange Agreements

Even in times of crisis, the banking system will probably not be able to find non-bank sellers of puts to balance these positions. 22/ For hedging purposes, the bank that writes the put can create a long position in a synthetic put by selling the weak currency forward, selling or selling spot on the futures market and selling a swap contract. Each of these operations triggers a spot sale of the weak currency to the Central Bank, as described above. Even if non-bank sellers of puts exist somewhere in the financial system, the selling bank seeking to hedge itself may not find them through the banking system. In times of crisis, the gross volume of trade increases, which means that many banks reach their credit ceilings with other banks. As the banking system becomes illiquid, transactions made by the credit banking system must now look for a spot market. As a hedge, the selling bank will place an order to buy a put in the organized money options market, where credit risk is not a problem, and will find the potential seller in this market. If the crisis progresses and more interbank credit lines fill up, volumes will tend to shift to safer organized exchanges. How important will the dynamic security response be? Figure 8 refers to the reaction of dynamic hedging programs in the final days of a managed or fixed exchange rate regime. In the days leading up to the collapse of an exchange band regime, the gradual devaluation of the spot exchange rate will have a significant impact on the hedging rate and will require a gradual increase in the short currency position. However, in the last hours or minutes of such a plan or an absolutely fixed exchange rate, the use of large interest rate increases to defend the fixed exchange rate may result in similar increases in the coverage rate.

What makes this effect important is that, in a fixed exchange rate regime or a quasi-fixed system such as the ERM, the limit values for the nominal exchange rate become hot spots for speculation on the direction of exchange rate change.

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