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The advantage to hiding one's hand: Speculation and central bank intervention in the foreign exchange market

  • Bhattacharya, Utpal
  • Weller, Paul

Using a portfolio balance model of exchange rate determination, this paper develops a theoretical explanation of why central banks do not make precise announcements of their exchange rate targets. In foreign exchange markets, where it is common knowledge that the central bank intervenes to stabilize the spot exchange rate around some target level, foreign exchange traders can exploit this fact to earn speculative profits from the central bank: this may cause the bank's reserves to fall to dangerous levels. We show that if the central bank is imprecise about its exchange rate targeting, it can use this informational advantage not only to reduce its reserve losses, but also to extract all relevant `fundamental' information from the traders. The imprecision, however, cannot be too large. There exist circumstances where the central bank finds it advantageous to reduce the market's ex ante uncertainty about the exchange rate target.

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Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 39 (1997)
Issue (Month): 2 (July)
Pages: 251-277

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Handle: RePEc:eee:moneco:v:39:y:1997:i:2:p:251-277
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505566

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  1. Maurice Obstfeld, 1990. "The Effectiveness of Foreign-Exchange Intervention: Recent Experience, 1985- 1988," NBER Chapters, in: International Policy Coordination and Exchange Rate Fluctuations, pages 197-246 National Bureau of Economic Research, Inc.
  2. Judd, Kenneth L., 1985. "The law of large numbers with a continuum of IID random variables," Journal of Economic Theory, Elsevier, vol. 35(1), pages 19-25, February.
  3. Laffont, Jean-Jacques & Maskin, Eric S, 1990. "The Efficient Market Hypothesis and Insider Trading on the Stock Market," Journal of Political Economy, University of Chicago Press, vol. 98(1), pages 70-93, February.
  4. Kathryn M. Dominguez, 1989. "Market Responses To Coordinated Central Bank Intervention," NBER Working Papers 3192, National Bureau of Economic Research, Inc.
  5. Ausubel, Lawrence M, 1990. "Insider Trading in a Rational Expectations Economy," American Economic Review, American Economic Association, vol. 80(5), pages 1022-41, December.
  6. Sanford J. Grossman, 1977. "The Existence of Futures Markets, Noisy Rational Expectations and Informational Externalities," Review of Economic Studies, Oxford University Press, vol. 44(3), pages 431-449.
  7. Paul Milgrom & Nancy L.Stokey, 1979. "Information, Trade, and Common Knowledge," Discussion Papers 377R, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  8. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  9. Bhattacharya, U. & Spiegel, M., 1989. "Insiders, Outsiders And Market Breakdowns," Papers fb-_89-20, Columbia - Graduate School of Business.
  10. Cukierman, Alex & Meltzer, Allan H, 1986. "A Theory of Ambiguity, Credibility, and Inflation under Discretion and Asymmetric Information," Econometrica, Econometric Society, vol. 54(5), pages 1099-1128, September.
  11. Grossman, Sanford J, 1976. "On the Efficiency of Competitive Stock Markets Where Trades Have Diverse Information," Journal of Finance, American Finance Association, vol. 31(2), pages 573-85, May.
  12. Donald B. Adams & Dale W. Henderson, 1983. "Definition and measurement of exchange market intervention," Staff Studies 126, Board of Governors of the Federal Reserve System (U.S.).
  13. Dominguez, Kathryn M & Frankel, Jeffrey A, 1993. "Does Foreign-Exchange Intervention Matter? The Portfolio Effect," American Economic Review, American Economic Association, vol. 83(5), pages 1356-69, December.
  14. Stephen A. Ross, 1977. "The Determination of Financial Structure: The Incentive-Signalling Approach," Bell Journal of Economics, The RAND Corporation, vol. 8(1), pages 23-40, Spring.
  15. Stein, Jeremy C, 1989. "Cheap Talk and the Fed: A Theory of Imprecise Policy Announcements," American Economic Review, American Economic Association, vol. 79(1), pages 32-42, March.
  16. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
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