Foreign exchange hedging with synthetic options and the interest rate defense of a fixed-exchange-rate regime

In the endgame of a fixed-exchange-rate regime, increases in interest rates to defend the currency may lead to an apparently perverse market response; further downward pressure on the exchange rate. This may result if a large proportion of investors' foreign exchange exposure is dynamically hedged. This paper describes the trading operations involved in implementing dynamic hedges and on the size and timing of the funding operations of those who are being squeezed relative to those engaged in dynamic hedging.