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Effectiveness of FX Intervention and the Flimsiness of Exchange rate Expectations

Hernando Vargas-Herrera () and Mauricio Villamizar-Villegas ()

Borradores de Economia from Banco de la Republica de Colombia

Abstract: Most of the foreign exchange intervention literature overlooks the influence of market uncertainty when evaluating effectiveness. In this paper we take a fresh new look at how this uncertainty amplifies exchange rate effects. Our contribution is twofold. We first posit a partial equilibrium model with frictions to illustrate that when uncertainty is low, intervention is less effective, for agents are willing to bet against the central bank. Conversely, when uncertainty is high, intervention faces a weaker countervailing force from speculators and arbitragers. Second, we empirically test for the incremental effects of flimsy exchange rate fundamentals by using a sharp policy discontinuity in the way the Central Bank of Colombia intervened in the FX market. Our results indicate that market uncertainty increases depreciation of domestic currency in approximately 1% following central bank purchases of foreign currency and extends its duration in up to 2 weeks. Additionally, these purchases have an incremental effect in stemming exchange rate volatility in up to 7%. **** RESUMEN: En este trabajo examinamos la influencia de la incertidumbre sobre la tasa de cambio futura en la efectividad de la intervención cambiaria. Nuestra contribución consta de dos partes. Primero, desarrollamos un modelo teórico de equilibrio parcial para ilustrar cómo la efectividad cambiaria aumenta a medida que aumenta la incertidumbre sobre la tasa de cambio futura o de sus determinantes. Segundo, presentamos evidencia empírica de esta relación haciendo uso del esquema de intervención cambiaria del Banco de la República, empleado durante el periodo 2002-2012, a través de opciones put de volatilidad. Nuestros resultados indican que, en presencia de alta incertidumbre en los fundamentales de la tasa de cambio, la efectividad de la intervención esterilizada aumenta en aproximadamente 1% y su duración se extiende hasta por dos semanas. Adicionalmente, encontramos que, en períodos de alta incertidumbre, la intervención reduce la volatilidad cambiaria hasta en un 7% adicional.

Keywords: Sterilized FX intervention; Exchange rate uncertainty; policy discontinuity; incremental effect of intervention; Regression Discontinuity Design; Intervención cambiaria esterilizada; incertidumbre sobre la tasa de cambio futura; efecto incremental de la intervención cambiaria; regresión discontinua (search for similar items in EconPapers)
JEL-codes: C14 C31 E58 F31 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mac and nep-mon
Date: 2019-04
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Persistent link: https://EconPapers.repec.org/RePEc:bdr:borrec:1070

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