Foreign Exchange Intervention Rules for Central Banks: A Risk-based Framework

February 12, 2021

Preview Citation

Format: Chicago

Romain Lafarguette, and Romain M Veyrune. Foreign Exchange Intervention Rules for Central Banks: A Risk-based Framework, (USA: International Monetary Fund, 2021) accessed November 21, 2024

Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary

This paper presents a rule for foreign exchange interventions (FXI), designed to preserve financial stability in floating exchange rate arrangements. The FXI rule addresses a market failure: the absence of hedging solution for tail exchange rate risk in the market (i.e. high volatility). Market impairment or overshoot of exchange rate between two equilibria could generate high volatility and threaten financial stability due to unhedged exposure to exchange rate risk in the economy. The rule uses the concept of Value at Risk (VaR) to define FXI triggers. While it provides to the market a hedge against tail risk, the rule allows the exchange rate to smoothly adjust to new equilibria. In addition, the rule is budget neutral over the medium term, encourages a prudent risk management in the market, and is more resilient to speculative attacks than other rules, such as fixed-volatility rules. The empirical methodology is backtested on Banco Mexico’s FXIs data between 2008 and 2016.

Subject: Currency markets, Exchange rate risk, Exchange rates, Foreign exchange, Vector autoregression

Keywords: Central bank intervention frequency, Foreign Exchange Interventions, FXI risk mitigation, GARCH, Intervention region, Market participant, Value at Risk, Var FX intervention rule, WP

Publication Details

Pages:

33
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2021/032
Stock No:

WPIEA2021032
ISBN:

9781513569406
ISSN:

1018-5941

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