Optimal intervention in the foreign exchange market when interventions affect market dynamics

Alec N. Kercheval, Juan F. Moreno

We address the problem of optimal Central Bank intervention in the exchange rate market when interventions create feedback in the rate dynamics. In particular, we extend the work done on optimal impulse control by Cadenillas and Zapatero (1999, 2000) to incorporate temporary market reactions to Bank interventions. We obtain new explicit optimal impulse control strategies that account for these market reactions.

Key words: impulse control, foreign exchange intervention, quasi-variational inequalities.