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Exchange Rate Intervention with Options

Author

Listed:
  • Fernando Zapatero

    (Centro de Investigacion Economica (CIE), Instituto Tecnologico Autonomo de Mexico (ITAM))

  • Luis F. Reverter

    (Banco de Mexico)

Abstract

We consider the problem of a Central Bank that has some exchange rate goals. We compare "direct" Intervention through sale/purchase of reserves in the currency market with an alternative strategy of intervention with options. The intervention affects the currency markets because as a result of the purchase and sale of derivatives, the investment bank the Central Bank deals with will have to cover its positions and therefore buy or sell the underlying security. In fact this strategy will affect not only the currency market but also the bond market and, therefore, the equilibrium interest rate, since the hedging strategy involves trade in the riskfree security, We simulate diferent dynamics of the demand and supply of both markets (currency and bonds) involved and compare the loss of reserves of the Central bank in either type of strategy as well as its effect in the volatility of both equilibrium exchange rate and equilibrium interest rate. Our framework us general enough to allow comparative statics for diferent parameter values of the model. Central bank intervention seems to have some advantages but the value of the cross-elasticity exchange rate-interest rate is crucial.

Suggested Citation

  • Fernando Zapatero & Luis F. Reverter, 1997. "Exchange Rate Intervention with Options," Working Papers 9710, Centro de Investigacion Economica, ITAM, revised Sep 1997.
    • Handle: RePEc:cie:wpaper:9710
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    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange

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