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

Romain Lafarguette and Romain Veyrune

No 2021/032, IMF Working Papers from International Monetary Fund

Abstract: 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.

Keywords: Foreign Exchange Interventions; Value at Risk; GARCH; WP; var FX intervention rule; intervention region; central bank intervention frequency; FXI risk mitigation; market participant (search for similar items in EconPapers)
Pages: 33
Date: 2021-02-12
New Economics Papers: this item is included in nep-mon and nep-rmg
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