The Brazilian Strategy and the Interventions to Manage Risk of Foreign Currency Exposure During Crisis

Abstract

Even in a floating foreign exchange rate regime monetary authorities sometimes intervene in the currency market due to liquidity demand and foreign exchange crisis. Typically, central banks intervene using foreign currency trades and/or changing domestic interest rates. We discuss this framework in the context of an optimal impulse stochastic control model. The control and the performance equations consider interventions with swap operations in the domestic market since Central Bank of Brazil also use these operations. We evaluate risk management strategies for central bank interventions in case of crisis based on the model. We conclude that the Brazilian risk management strategy of increasing international reserves holdings and decreasing foreign exchange rate short exposure on public domestic debt after 2004 gave more flexibility to the country to manage foreign exchange rate risk in 2008 and to avoid higher interest rates to attract international capital as it was necessary in previous crises.