A central bank strategy for defending a currency peg

DOI10.1016/J.SYSCONLE.2020.104761MaRDI QIDQ826751zbMATH OpenOpenAlexFDO

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

Publication date 6 January 2021

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

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

zbMATH Keywords

central bank interventioncurrency pegcurrency target zoneprice impactsecond-order differential equation with infinite boundary conditionssingular stochastic control

Mathematics Subject Classification ID

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

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.

Recommendations

• How to devalue exchange rates, without building up reserves: strategic theory for central banking
• Protecting pegged currency markets from speculative investors
• Exchange rate pegs, fiscal policy and credibility
• Currency manipulation and currency wars: analyzing the dynamics of competitive central bank interventions
• Stabilization policy in a currency union
• On exchange-rate stabilization
• Reserve currencies in an evolving international monetary system
• Monetary policy strategies for the European Central Bank
• On the sustainability of exchange rate target zones with central parity realignments
• A defense of the FOMC

Cites work

• Classical and impulse stochastic control of the exchange rate using interest rates and reserves.
• Detecting mean reversion within reflecting barriers: application to the European Exchange Rate Mechanism
• Impulse Control Method and Exchange Rate
• No-dynamic-arbitrage and market impact
• Nonlinear elliptic equations with singular boundary conditions and stochastic control with state constraints. I: The model problem
• Optimal Central Bank intervention in the foreign exchange market
• Optimal execution with nonlinear impact functions and trading-enhanced risk
• Optimal Impulse Control When Control Actions Have Random Consequences
• Optimal portfolio liquidation in target zone models and catalytic superprocesses
• Optimal stochastic intervention control with application to the exchange rate
• Quadratic covariation and an extension of Itô's formula

Cited in

(3)

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

This page was built for publication: A central bank strategy for defending a currency peg

Report a bug (only for logged in users!)Click here to report a bug for this page (MaRDI item Q826751)