TAILIEUCHUNG - Do High Interest Rates Defend Currencies During Speculative Attacks?

Measure risk: Accurate and timely measurement of risk is essential to effective risk management. A bank that does not have risk measurement tools has limited ability to control or monitor risk levels. Further, more sophisticated measurement tools are needed as the complexity of the risk increases. A bank should periodically test to make sure that the measurement tools it uses are accurate. Sound risk measurement tools assess the risks of individual transactions and portfolios, as well as interdependencies, correlations, and aggregate risks across portfolios and lines of business. During bank mergers and consolidations, the effectiveness of risk measurement tools is. | Do High Interest Rates Defend Currencies During Speculative Attacks Aart Kraay The World Bank December 2001 Abstract Do high interest rates defend currencies during speculative attacks Or do they have the perverse effect of increasing the probability of a devaluation of the currency under attack Drawing on evidence from a large sample of speculative attacks in developed and developing economies this paper argues that the answer to both questions is no . In particular this paper documents a striking lack of any systematic association whatsoever between interest rates and the outcome of speculative attacks. The lack of clear empirical evidence on the effects of high interest rates during speculative attacks mirrors the theoretical ambiguities on this issue. 1818 H Street . Washington DC 20433 202 473-5756 akraay@. The opinions expressed in this paper are the author s and do not reflect those of the World Bank its executive directors or the countries they represent. I would like to thank Alan Drazen Ilan Goldfajn Patrick Honohan Vickie Kraay Maria Soledad Martinez Peria Sergio Schmukler Jakob Svensson Jaume Ventura seminar participants at MIT Princeton the Tinbergen Institute and the World Bank and three anonymous referees for helpful comments. 1. Introduction According to conventional wisdom currencies that come under speculative attack can be defended with high interest rates. By raising interest rates high enough the monetary authority can make it prohibitively costly for speculators to take short positions in the currency under attack. High interest rates may also convey a positive signal regarding the commitment of the monetary authority to maintaining a fixed exchange rate. According to the contrarian view neither of these mechanisms is persuasive. Interest rates have to be increased to very high annualized rates in order to entice investors to hold local currency-denominated assets in the face of a small expected devaluation over a short horizon

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