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Brazilian Strategy for Managing the Risk of Foreign Exchange Rate Exposure During a Crisis

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  • Antonio Francisco A. Silva Jr.
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    Abstract

    Even in a floating foreign exchange rate regime, monetary authorities sometimes intervene in the currency market due to liquidity demand and foreign exchange crises. Typically, central banks intervene using foreign currency trades and/or by changing domestic interest rates. We discuss this framework in the context of an optimal impulse stochastic control model. The control and performance equations include interventions with swap operations in the domestic market, since the Central Bank of Brazil also uses these operations. We evaluate risk management strategies for central bank interventions in case of crisis based on the model. We conclude that the Brazilian risk management strategy of increasing holdings of international reserves and decreasing short foreign exchange rate exposure in domestic public debt after 2004 gave the country more flexibility to manage foreign exchange rate risk in 2008 and to avoid higher interest rates to attract international capital as was necessary in previous crises.

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    File URL: http://www.bcb.gov.br/pec/wps/ingl/wps207.pdf
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    Bibliographic Info

    Paper provided by Central Bank of Brazil, Research Department in its series Working Papers Series with number 207.

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    Date of creation: Apr 2010
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    Handle: RePEc:bcb:wpaper:207

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    Web page: http://www.bcb.gov.br/?english

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    1. Mundaca, Gabriela & Oksendal, Bernt, 1998. "Optimal stochastic intervention control with application to the exchange rate," Journal of Mathematical Economics, Elsevier, vol. 29(2), pages 225-243, March.
    2. Paul Krugman & Marcus Miller, 1992. "Exchange Rate Targets and Currency Bands," NBER Books, National Bureau of Economic Research, Inc, number krug92-1, octubre-d.
    3. Krugman, Paul R, 1991. "Target Zones and Exchange Rate Dynamics," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 669-82, August.
    4. Robert P. Flood & Nancy P. Marion, 2002. "Holding International Reserves in an Era of High Capital Mobility," IMF Working Papers 02/62, International Monetary Fund.
    5. Lutz Kilian & Mark P. Taylor, 2001. "Why is it so difficult to beat the Random Walk Forecast of Exchange Rates?," Tinbergen Institute Discussion Papers 01-031/4, Tinbergen Institute.
    6. Abel Cadenillas & Fernando Zapatero, 2000. "Classical and Impulse Stochastic Control of the Exchange Rate Using Interest Rates and Reserves," Mathematical Finance, Wiley Blackwell, vol. 10(2), pages 141-156.
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    Cited by:
    1. Antonio Francisco A. Silva Jr, 2011. "The Self-insurance Role of International Reserves and the 2008-2010 Crisis," Working Papers Series 256, Central Bank of Brazil, Research Department.

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