The effects of central bank intervention on the volatility of exchange rates: Evidence from the spot and options market

The flexible exchange rate period officially began in 1973 with the complete collapse of the Bretton Woods agreements. It ushered in a period of intense exchange rate volatility. Since the excessive variability often affected the economy, central banks began to intervene to support the dollar in the foreign exchange market. An analysis of the effects of central bank interventions on the exchange market is presented. There have been many contradictory study results as to whether central bank interventions decrease or increase volatilities of exchange rates. We examine two effects of the intervention: One is the effect of central bank interventions on the levels of the volatilities of the DM and the YEN exchange rates. The other is the intervention effects on the changes in the implied volatilities of both currencies in the foreign currency options market during the post-Louvre period. Our main conclusions derived from our research are as follow: The effects of interventions of the Federal Reserve, Bundesbank, and Bank of Japan on the volatilities of the DM and the YEN exchange rates were positive and significant. In other words, the intervention policies of the central banks increased the volatilities of the DM and the YEN exchange rates during the post-Louvre period. Next, the intervention effects on the changes in the implied volatilities of the DM and the YEN exchange rate was also positive and significant in the foreign currency options market. In other words, the intervention policies increased the magnitude of volatilities in the exchange market during the post-Louvre period. In this sense, if the intervention purpose was to decrease the volatilities, we can conclude that the intervention policies were unsuccessful attaining their goals during the post-Louvre period.