Exchange Rate Systems

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Chapter 5
Exchange Rate Systems


1. How can you quantify currency risk in a floating exchange rate system?

Answer: To characterize the risk of a currency position, you must try to characterize the conditional distribution of the future exchange rate changes. With floating exchange rates, historical information provides useful information about this distribution. For example, you can use data to measure the average historical dispersion (standard deviation or volatility) of the distribution. The higher this volatility, the riskier are positions in this currency. It is also possible to rely on more forward-looking information using the options markets (see Chapter 20). Finally, we should point out that volatility
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How can a central bank offset this effect and still hope to influence the exchange rate?

Answer: When a central bank buys (sells) foreign currency, its international reserves increase (decrease), and the money supply increases (decreases) simultaneously. To offset the effect on the money supply, the foreign exchange intervention can be sterilized; that is, the central bank can perform an open market operation that counteracts the effect on the money supply of the original foreign exchange intervention. The direct effects of a sterilized intervention are two-fold. First, it forces a portfolio shift on private investors, by replacing foreign bonds with domestic bonds (or vice versa). This may affect expectations and prices. Second, the actions of the central bank in the foreign exchange markets, while very small relative to the nominal trading volumes, may still manage to squeeze foreign exchange inventories at dealer banks and generate pricing effects. Indirectly, the central bank can signal its opinion on the fundamental value of the exchange rate through an intervention that consequently affects market expectations. There is no consensus on how effective sterilized interventions are in affecting the level and volatility of exchange rates.

8. How can a central bank peg the value of its currency relative to another currency?

Answer: To peg the value of its currency to another currency, the government must make a market in the two
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