Paolo Vitale

A Transaction Level Study of the Effects of Central Bank Intervention on Exchange Rates

We study the effects of sterilised intervention operations executed on behalf of the Swiss National Bank (SNB) using tick-by-tick transactions data between 1986 and 1995. We extend the preliminary results obtained by Fischer and Zurlinden (1991) by matching these data with intra-day indicative exchange rate quotes. Via an event study analysis we examine the effects of intervention on exchange rate returns and volatility. We find that intervention has important short-run effects on the level of exchanges rates. There are also significant intra-day effects of intervention on exchange rate volatility. All of these effects are in line with theoretical predictions and it is shown that the impact on the exchange rate level is stronger when intervention is with the market rather than when it is again the wind. Finally, we find that the market partially anticipates the information contained in interventions as the exchange rate reacts in the 15 minute interval immediately before an event.

A Guided Tour of the Market Microstructure Approach to Exchange Rate Determination

We propose a critical review of recent developments in exchange rate economics. This new strand of research is motivated by some very stark empirical evidence, relating exchange rate returns to order flow. Plenty of empirical evidence shows that order flow, i.e. the imbalance in the sequence of purchases and sales of foreign currencies in the markets for foreign exchange, is an extremely powerful determinant of short-run exchange rate movements. With a simplified analytical framework we see how, according to the rational expectation paradigm of asset pricing, such a relation reflects liquidity and information effects of portfolios shifts.

Foreign exchange intervention: how to signal policy objectives and stabilise the economy

Abstract Within a simple model of monetary policy for an open economy, we study how foreign exchange intervention may be used as a costly signal of the policy makers’ objectives. Our analysis indicates that: (i) foreign exchange intervention typically stabilises the national economy, reducing the fluctuations of employment and output; (ii) this result is sensitive to the institutional structure of decision-making, in that a larger stability gain is obtained when foreign exchange intervention and monetary policy are kept under the jurisdiction of different governmental agencies.

Two Months In The Life Of Several Gilt-Edged Market Makers On The London Stock Exchange

Abstract We investigate the micro structure of the UK gilt market studying the behaviour of several gilt-edged market makers on the London Stock Exchange. Through a structural model of the price process we can test different microstructural hypotheses, concerning information asymmetries, transaction and inventory carrying costs, and market liquidity. Our results suggest that inventories do not alter the price process in the gilt market. Moreover, in contrast to customer orders, inter-dealer transactions possess an information content. Transaction costs in the inter-dealer market are also substantially smaller than those for external customers.

Optimal Informed Trading in the Foreign Exchange Market

We formulate a market microstructure model of exchange determination that we employ to investigate the impact of informed trading on exchange rates and on foreign exchange (FX) market conditions. With our formulation, we show how strategic informed agents influence exchange rates via both the portfolio-balance and information effects. We outline the connection which exists between the private value of information, market efficiency, liquidity and exchange rate volatility. Our model is also consistent with recent empirical research on the micro-structure of FX markets.

Pessimistic Optimal Choice for Risk-Averse Agents

We propose a general framework for the analysis of dynamic optimization with risk- averse agents, extending WhittleOs (Whittle, 1990) formulation of risk-sensitive optimal control problems to accommodate time-discounting. We show how, within a Markovian set-up, optimal risk-averse behavior is identified via a pessimistic choice mechanism and described by simple recursive formulae. We apply this methodology to two distinct problems formulated respectively in discrete- and continuous-time. In the former, we extend SvennsonOs (Svennson, 1997) analysis of optimal monetary policy, showing that with a risk-averse central bank the inflation forecast is not longer an explicit intermediate target, the monetary authorities do not expect the inflation rate to mean revert to its target level and apply a more aggressive Taylor rule than under risk-neutrality, while the inflation rate is less volatile. In the latter, we investigate the optimal production policy of a monopolist which faces a demand schedule subject to stochastic shocks, once again showing that risk-aversion induces her to act more aggressively.

Inflation and Sovereign Default

Recent research has highlighted the role that the government budget constraint plays in determining the consumer price level. According to the fiscal approach to price determination, prices adjust so that the discounted value of future real government primary surpluses equals the current real value of public debt. An important implication is that the probability of a crisis involving default on public debt may directly affect consumer prices. This paper examines the interaction of prices and sovereign insolvency crises using simple, continuous-time models of the government budget constraint.

Reserve and exchange rate cycles

Abstract Many Latin American countries appear locked into cycles of reserve loss, devaluation and temporary reserve gains. This paper shows how a dual exchange rate system with leakages may generate cycles in reserves and the premium between official and parallel exchange rates. We study the dynamics of these cycles and their asymptotic behavior both analytically and numerically.

Linear Risk-averse Optimal Control Problems: Applications in Economics and Finance

We discuss how Whittles (Whittle, 1990) approach to risk-sensitive optimal control problems can be applied in economics and finance. We show how his analysis of the class of Linear Exponential Quadratic Gaussian problems can be extended to accommodate time-discounting, while preserving its simple and general recursive solutions. We apply Whittles methodology investigating two specific problems in financial economics and monetary policy.

Optimal Climate Policy for a Pessimistic Social Planner

In this paper we characterize the preferences of a pessimistic social planner concerned with the potential costs of extreme, low-probability climate events. This pessimistic attitude is represented by a recursive optimization criterion à la Hansen and Sargent (1995) that introduces supplementary curvature in the social preferences of standard linear-quadratic optimization analysis and, under certain conditions, it can be shown to correspond to the Epstein-Zin recursive utility. The introduction of extra convexity and the separation between risk-aversion and time-preference implies that, independently of the choice of the discount rate, a sharp, early and steady mitigation effort arises as the optimal climate policy, supporting the main recommendation of the Stern Review (Stern, 2007). Nonetheless, we accommodate for its main criticism of using a too low and questionable discount rate (Nordhaus, 2007), while preserving the assumption of a normal (thin-tailed) probability distribution (Weitzman, 2009). Finally, we argue that our theoretical framework is sufficiently general and robust to possible mis-specifications of the model.