When a country’s currency is enduring extreme and unnecessary upward or downward financial pressure, (usually caused by high volatility from a surge of trading by speculators and market players) a government or central bank will use Forex market intervention to stabilize the situation. Central bank intervention can be used to boost or decrease a currencies value, most commonly for boosting or decreasing productivity and exports of a nation. Central banks, especially those in developing countries, intervene in the foreign exchange market to build reserves for themselves or provide them to the country's banks. Their aim is often to stabilize the exchange rate.
Foreign exchange intervention operations are a controversial policy option for central banks. In one view, exemplified by the Wall Street Journal quote, intervention policy is not only ineffective in influencing the level of the exchange rate, but also dangerous, because it can increase the volatility of the rate. Others argue that intervention operations can influence the level of the exchange rate, and can also ‘calm disorderly markets’, thereby decreasing volatility. Yet others argue that intervention operations are inconsequential since they neither affect the level nor the volatility of exchange rates.
Currency interventions are generally characterized as either sterilized or non-sterilized transactions, depending on whether it changes the monetary base. Both methods involve buying and selling foreign currencies - or bonds denominated in those currencies - to either increase or decrease the value of their currency in the global foreign exchange market. Sterilized transactions are designed to influence exchange rates without changing the monetary base by buying or selling foreign currency denominated bonds while simultaneously buying and selling domestic currency bonds to offset the amount.
Non-sterilized transactions involve simply buying or selling foreign currency bonds with domestic currency without the offsetting transaction. Central banks can also opt to directly intervene in the currency markets through spot and forward market transactions. These transactions involve directly purchasing foreign currency with domestic currency or vice versa, with delivery times of a few days to several weeks. The goal in these transactions is to affect currency values in the very near-term.
Traders must keep in mind that when central banks intervene in the forex market, moves can be extremely volatile. Therefore, it is essential to set an appropriate risk to reward ratio and make use of prudent risk management. Central banks intervene in the forex market when the current trend is in the opposite direction to where the central bank desires the exchange rate to be. Therefore, trading around central bank intervention is a lot like trading reversals. Additionally, the forex market tends to anticipate central bank intervention meaning that it is not uncommon to see movements against the long-term trend in the moments leading up to central bank intervention.
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