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

IMF Working Papers, February 12, 2021

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

Authors: Romain Lafarguette, Romain M Veyrune
Publication date: February 12, 2021
Purpose: Presents a rule for foreign exchange interventions (FXI) designed to preserve financial stability in floating exchange rate arrangements by addressing a market failure: the absence of hedging solution for tail exchange rate risk in the market (i.e. high volatility).
Core mechanism: Uses the concept of Value at Risk (VaR) to define FXI triggers that provide the market a hedge against tail risk while allowing the exchange rate to smoothly adjust to new equilibria.
Empirical scope: Backtested on Banco Mexico’s FXIs data between 2008 and 2016.

Addresses market failure from lack of hedging solutions for tail exchange rate risk.
Uses Value at Risk (VaR) to define intervention triggers.
Provides to the market a hedge against tail risk while permitting smooth exchange rate adjustment to new equilibria.
Budget neutrality: The rule is budget neutral over the medium term.
Market incentives: Encourages prudent risk management in the market.
Resilience: More resilient to speculative attacks than other rules, such as fixed-volatility rules.

Empirical methodology: Backtested on Banco Mexico’s FXIs data between 2008 and 2016.
Key analytical concepts mentioned: Value at Risk (VaR), GARCH, Vector autoregression.
Subjects and keywords used in the analysis: Currency markets, Exchange rate risk, Exchange rates, Foreign exchange, Vector autoregression; central bank intervention frequency, Foreign Exchange Interventions, FXI risk mitigation, GARCH, intervention region, market participant, Value at Risk, var FX intervention rule, WP.

Implement an FXI rule based on VaR to mitigate tail exchange rate risk when market hedging solutions are absent.
Design interventions to be budget neutral over the medium term to avoid fiscal stress from FXI operations.
Favor rules that preserve exchange rate flexibility and allow smooth adjustment to new equilibria rather than fixed-volatility rules that may be more vulnerable to speculative attacks.
Encourage market mechanisms and regulation that promote prudent risk management among market participants.