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Central Bank Intervention in USD/INR Market: Estimating Its Reaction Function and Impact on Volatility

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Abstract

Econometric evidence on why central banks intervene in the foreign exchange market and the impact of such intervention has remained inconclusive. We contribute to the literature with evidence from India, a managed float regime that sees consistent monitoring and intervention by Reserve Bank of India, India’s central bank. Estimation of the central bank reaction function shows that increased volatility in the foreign exchange market and misalignment from targeted rates are important objectives behind intervention. The paper further uses the GARCH framework to study how intervention influences exchange rate volatility. We find that intervention in the spot market increases volatility while that in the forward market reduces volatility.

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Notes

  1. The motivations behind ‘leaning against the wind’ and ‘leaning for the wind’ policies are different. In the former case, central bank attempts to reverse the direction of exchange rate movement while in the latter the motive is to reduce the extent of volatility only.

  2. Exchange rate is defined as number of domestic currency units for one unit of foreign currency.

  3. Nominal effective exchange rate is the weighted averages of bilateral exchange rates of domestic currency in terms of foreign currency and REER is the weighted average of NEER adjusted by the ratio of domestic price to foreign prices. The weights for the 36-currency Trade based REER (Export based REER) index are based on the normalized geometric average of India’s bilateral trade (exports) with countries/regions represented by the 36 currencies during the preceding three years (RBI 2005).

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Acknowledgments

The authors thank the editor and two anonymous referees for useful comments and suggestions. The views and opinions expressed in the paper belong to the authors and do not, in any way, reflect the views of the institutions the authors represent.

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Authors and Affiliations

  1. National Institute of Bank Management (NIBM), NIBM Campus, Pune-48, India

    Smita Roy Trivedi

  2. Narsee Monji Institute of Management Studies, Mumbai, India

    P. G. Apte

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  1. Smita Roy Trivedi
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  2. P. G. Apte
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Correspondence to Smita Roy Trivedi.

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P. G. Apte: Formerly Adjunct Professor, NIBM and Director, Indian Institute of Management Bangalore (IIM-B).

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Roy Trivedi, S., Apte, P.G. Central Bank Intervention in USD/INR Market: Estimating Its Reaction Function and Impact on Volatility. Asia-Pac Financ Markets 23, 263–279 (2016). https://doi.org/10.1007/s10690-016-9218-6

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