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Central bank intervention with limited arbitrage†
Article first published online: 30 MAR 2007
Copyright © 2007 John Wiley & Sons, Ltd.
International Journal of Finance & Economics
Special Issue: Exchange Rate Intervention
Volume 12, Issue 2, pages 249–260, April 2007
How to Cite
Neely, C. J. and Weller, P. A. (2007), Central bank intervention with limited arbitrage. Int. J. Fin. Econ., 12: 249–260. doi: 10.1002/ijfe.328
- Issue published online: 19 APR 2007
- Article first published online: 30 MAR 2007
- foreign exchange;
- limits to arbitrage;
- noise trader
Shleifer and Vishny (SV) 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, SV 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 analyse a generalized SV 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. Copyright © 2007 John Wiley & Sons, Ltd.