FX Interventions and Capital-Constrained Banks: Evidence from USD/ILS Spot, Forward, and Option Markets

This paper uses confidential daily data on the Bank of Israel’s (BOI) foreign exchange purchase program in the USD/Israeli new shekel (ILS) spot market from 2013 to 2019 to study how FX interventions affect the spot exchange rate, the forward rate (through covered interest parity deviations), and the risk-neutral probability distribution of future exchange rates reflected in the options market. Interventions of USD 1 billion are found to be associated on average with a depreciation of the ILS by 0.82%–0.85%—at the upper bound of estimates in the existing literature—while the indirect effect on the forward rate is smaller because the BOI’s USD purchases widen the negative deviation from covered interest parity (CIP). The higher moments of the risk-neutral distribution—including crash risk—are found to be unaffected; USD purchases shift the entire distribution toward higher USD/ILS values without altering its shape. An additional finding is that the USD/ILS options market appears to anticipate intervention episodes and prices them in before they occur. This paper is the first academic study to empirically quantify the effect of FX interventions on CIP deviations. Note: this summary is based on Bundesbank DP 20/2022 “Foreign exchange interventions and their impact on expectations: Evidence from the USD/ILS options market,” an earlier version; the published JMCB paper title indicates expanded scope including capital-constrained banks and spot/forward/option markets.

Daniel Nathan | Macro Paper Warehouse

FX Interventions and Capital-Constrained Banks: Evidence from USD/ILS Spot, Forward, and Option Markets