Currency Markets
Modelling intervention

Speculators in currency markets exploit their knowledge that central banks intervene to stabilize spot exchange rates around target levels, while central banks in turn seek to account for the anticipated reactions of speculative traders to prevent their reserves from falling to dangerous levels. In Discussion Paper No. 737, Utpal Bhattacharya and Research Fellow Paul Weller use a portfolio balance model of exchange rate determination to analyse this strategic interaction, assuming that central banks have exchange rate targets that may be inconsistent with the fundamentals in the short run. They find that central banks can limit their intervention costs by keeping their own exchange rate targets secret and that their large role enables them to preserve this informational advantage; this result is consistent with a number of observations.

First, the introduction of asymmetric information and strategic behaviour allows the very act of intervention to reveal information, which accounts for exchange rates' sensitivity to even the small interventions that occur in practice. Second, the apparent inconsistency that central bank intervention can destabilize currency markets is explicable once the exchange rate target's equilibrium value is no longer necessarily its `fundamental' value. Third, although sophisticated speculators can take advantage of predictable behaviour by central banks, which will therefore make losses on average, the ambiguity of a central bank's target enables it to minimize these losses. Fourth, intervention policy is sometimes motivated by a desire to control markets' responses to unanticipated policy changes. Fifth, exchange rate volatility increased during the pre-Louvre period and reduced thereafter. The authors conclude that imprecise exchange rate targets render sterilized intervention an effective means of stabilization, although central banks may benefit from credible announcements of short-run targets: there is a trade-off between the reduction of uncertainty and hence of targeting costs and the loss of its informational advantage.

The Advantage to Hiding One's Hand: Speculation and Central Bank
Intervention in the Foreign Exchange Market
Utpal Bhattacharya and Paul Weller

Discussion Paper No. 737, November 1992 (IM)