A central bank strategy for defending a currency peg

DOI10.1016/J.SYSCONLE.2020.104761zbMATH Open1454.91138arXiv2008.00470OpenAlexW2996325452MaRDI QIDQ826751FDOQ826751

Authors: Eyal Neuman, Alexander Schied, Chengguo Weng, Xiaole Xue 

Publication date: 6 January 2021

Published in: Systems \& Control Letters (Search for Journal in Brave)

Abstract: We consider a central bank strategy for maintaining a two-sided currency target zone, in which an exchange rate of two currencies is forced to stay between two thresholds. To keep the exchange rate from breaking the prescribed barriers, the central bank is generating permanent price impact and thereby accumulating inventory in the foreign currency. Historical examples of failed target zones illustrate that this inventory can become problematic, in particular when there is an adverse macroeconomic trend in the market. We model this situation through a continuous-time market impact model of Almgren--Chriss-type with drift, in which the exchange rate is a diffusion process controlled by the price impact of the central bank's intervention strategy. The objective of the central bank is to enforce the target zone through a strategy that minimizes the accumulated inventory. We formulate this objective as a stochastic control problem with random time horizon. It is solved by reduction to a singular boundary value problem that was solved by Lasry and Lions (1989). Finally, we provide numerical simulations of optimally controlled exchange rate processes and the corresponding evolution of the central bank inventory.

Full work available at URL: https://arxiv.org/abs/2008.00470

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zbMATH Keywords

price impactsingular stochastic controlcentral bank interventioncurrency pegcurrency target zonesecond-order differential equation with infinite boundary conditions

Mathematics Subject Classification ID

Macroeconomic theory (monetary models, models of taxation) (91B64)

Cites Work

• No-dynamic-arbitrage and market impact
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• Quadratic covariation and an extension of Itô's formula
• Impulse Control Method and Exchange Rate
• Optimal Central Bank intervention in the foreign exchange market
• Optimal stochastic intervention control with application to the exchange rate
• Optimal Impulse Control When Control Actions Have Random Consequences

Cited In (3)

• Protecting pegged currency markets from speculative investors
• A mathematical model and the optimal strategy in the transactions between one bank and the Central Bank
• Optimal Execution: A Review

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