Realized Volatility as an Instrument to Official Intervention

Abstract

This chapter proposes a novel orthogonality condition based on realized volatility that allows instrumental variable estimation of the effects of spot intervention in foreign exchange markets. We consider parametric and nonparametric instrumental variable estimation and propose a test based on the average treatment effect of intervention. We apply the method to a unique dataset for the BRL/USD market with full records of spot intervention and net order flow intermediated by the financial system. Overall the average effect of a one billion dollars sell or buy intervention is close to 0.51% depreciation or appreciation, respectively, estimated in the linear framework, which is therefore robust to nonlinear interactions. The estimates are a bit lower when controlling for derivative operations, which suggests the intervention policies (spot and swaps) are complementary.