Central Bank Reserves and Currency Volatility

We investigate the effects of sterilised Central Bank interventions designed to smooth exchange rate volatility but not aimed at a particular trend in the spot rate. We present a model in which the intervention flow is a nonlinear mapping of the market order flow. Simulations from our model show that small daily drifts that can arise from various reasons beyond the central bank’s control lead to major changes in both the stock of foreign reserves and the distribution of currency returns. The likelihood of a major impact increases with the Central Bank’s inability or reluctance to adopt a neutral policy regarding the exchange rate drifts. Using detailed intervention data from the Central Bank of Brazil, we provide empirical support for the link between exchange rate drifts and Central Bank interventions.