FX Interventions and Capital‐Constrained Banks: Evidence from USD/ILS Spot, Forward, and Option Markets
What this paper finds — and why it matters
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.
Summary of a forthcoming paper, AI-assisted and human-reviewed. See the linked original for the authoritative claims and full conditions.
Q1. What is the data and research design?
The paper uses confidential daily data on the BOI’s intervention program in the USD/ILS spot market from 2013 to 2019, together with USD/ILS option price data, to identify the effect of sterilized FX purchases on the spot rate, forward rate, and option-implied expectations. The authors note that results from older studies may not be representative because FX markets have changed substantially over the past decade and the sustained low-interest-rate environment of this period is historically exceptional, making updated empirical evidence important.
Q2. What is the estimated effect on the spot exchange rate?
Interventions of USD 1 billion are associated on average with a depreciation of the ILS by 0.82%–0.85%, which is at the upper bound of the estimated impact found in other studies. The direction is consistent with portfolio balance and signaling channels: BOI purchases of USD increase demand for dollars and supply of shekels, driving the spot USD/ILS rate higher.
Q3. How do interventions affect the forward rate and covered interest parity?
The indirect effect of BOI USD purchases on the forward rate is smaller than the spot effect because the purchases widen the negative deviation from covered interest parity—this paper is the first to empirically quantify the effect of FX interventions on CIP deviations. The CIP deviation widens because the spot rate moves more than the forward rate, creating a cross-currency basis that is not fully closed by the intervention.
Q4. How are the higher moments of the exchange rate distribution affected?
The higher moments of the risk-neutral probability distribution of future exchange rates—including crash risk—are found to be unaffected by BOI USD purchases; the purchases simply shift the entire distribution toward higher USD/ILS values without compressing its variance or altering its shape. This finding indicates that FX interventions move the level of expected future exchange rates but do not reduce tail risk or change the perceived skewness of the distribution from the market’s perspective.
Q5. Do options markets anticipate interventions?
The USD/ILS options market is found to anticipate intervention episodes and price them in before they occur. This anticipation is consistent with market participants forming rational expectations about the BOI’s reaction function based on observable exchange rate dynamics, and adjusting option prices accordingly ahead of actual intervention.
Key concepts
risk-neutral probability distribution (RND) : the probability distribution over future exchange rates recovered from observed option prices; reflects market forward-looking beliefs including higher moments such as crash risk and skewness, under risk-neutral pricing conventions.
covered interest parity (CIP) deviation (cross-currency basis) : the departure from the no-arbitrage relationship linking spot rates, forward rates, and interest rate differentials; a negative CIP deviation for the ILS means the forward USD premium exceeds the USD-ILS interest rate differential, implying the dollar is cheap in the forward market relative to the spot-and-roll strategy.
sterilized FX intervention : central bank foreign currency purchases or sales offset by domestic open market operations to prevent the domestic money supply from changing, isolating the exchange rate channel from monetary policy effects.