Optimal intervention in the foreign exchange market when interventions affect market dynamics

TL;DR

This paper develops explicit optimal intervention strategies for central banks in foreign exchange markets, accounting for temporary, stochastic market reactions to interventions, extending previous impulse control models.

Contribution

It introduces a novel impulse control framework that incorporates random market reactions, providing explicit strategies that differ from traditional models without such reactions.

Findings

Derived explicit optimal intervention strategies considering market reactions

Showed that strategies cannot be obtained by simply adjusting intervention costs

Extended previous models to more realistic market dynamics

Abstract

We address the problem of optimal Central Bank intervention in the exchange rate market when interventions create feedback in the rate dynamics. In particular, we extend the work done on optimal impulse control by Cadenillas and Zapatero to incorporate temporary market reactions, of random duration and level, to Bank interventions, and to establish results for more general rate processes. We obtain new explicit optimal impulse control strategies that account for these market reactions, and show that they cannot be obtained simply by adjusting the intervention cost in a model without market reactions.