Garber and Spencer have argued that dynamic hedging may lead to perverse results when interest rates are used to defend an exchange rate. This paper shows that interest rate changes have little effects on dynamic hedgers when volatility is high.

Using the Branson model as an example, this paper seeks to clarify the role of interest rate and exchange rate changes in asset market models. Focusing on short-term adjustments, it is shown that portfolio shifts mainly affect relative interest rates in different countries. Only to the extent...