Center for Mathematical Economics Working Papers No. 594
Consider the problem of a central bank that wants to manage the exchange rate between its domestic currency and a foreign one. The central bank can purchase and sell the foreign currency, and each intervention on the exchange market leads to a proportional cost whose instantaneous marginal value depends on the current level of the exchange rate. The central bank aims at minimizing the total expected costs of interventions on the exchange market, plus a total expected holding cost. We formulate this problem as an infinite time-horizon stochastic control problem with controls that have paths which are locally of bounded variation. The exchange rate evolves as a general linearly controlled one-dimensional diffusion, and the two nondecreasing processes giving the minimal decomposition of a bounded-variation control model the cumulative amount of foreign currency that has been purchased and sold by the central bank. We provide a complete solution to this problem by finding the explicit expression of the value function and a complete characterization of the optimal control. At each instant of time, the optimally controlled exchange rate is kept within a band whose size is endogenously determined as part of the solution to the problem. We also study the expected exit time from the band, and the sensitivity of the width of the band with respect to the model's parameters in the case when the exchange rate evolves (in absence of any intervention) as an Ornstein-Uhlenbeck process, and the marginal costs of controls are constant. The techniques employed in the paper are those of the theory of singular stochastic control and of one-dimensional diffusions.
singular stochastic control exchange rates target zones central bank variational inequality optimal stopping