Exchange expectations, adverse selection and liquidity
Expectativas cambiarias, selección adversa y liquidez
DOI:
https://doi.org/10.29105/ensayos33.1-2Keywords:
Technical Analysis, Adverse Selection, Exchange Rate Expectations, Market Liquidity, Mechanism Design, Government Direct LendingAbstract
This paper evaluates the short-term implications of exchange rate expectations in credit markets affected by adverse selection. It presents a model for a credit market in which debt contracts are contingent on the income of borrowers. Since legacy assets are denominated in a foreign currency, contracts are written using these expectations based on the premises of technical analysis. In this model, the adverse exchange rate trend generates public signals which can move the market from one equilibrium, where all firms invest, to another, where only a fraction do, which defines the space for government intervention. Thus, from a policy perspective; if the government wants to restore the credit market by using direct lending programs such as the discount window, it has to increase the size of the program. Otherwise, an overreaction in the interest rate could dry up liquidity and prevent firms from investing.
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