1 s2.0 S0261560613000624 Main

Journal of International Money and Finance 37 (2013) 25–47
Contents lists available at SciVerse ScienceDirect
Journal of International Money

and Finance
journal homepage: www.elsevier.com/locate/jimf
Currency intervention: A case study

of an emerging marketq
Renée A. Fry-McKibbin a, *, Sumila Wanaguru a, b
a
Centre for Applied Macroeconomic Analysis (CAMA), Crawford School of Public Policy,
The Australian National University, Canberra, ACT 0200, Australia
b
Central Bank of Sri Lanka, Sri Lanka
a b s t r a c t
JEL classification: Using a unique dataset on daily foreign exchange intervention and
F31 a new methodological framework of a latent factor model of
F36 central bank intervention, this paper addresses the effects of
F41
intervention in an emerging market. Events in financial markets
Keywords: from 2002 to 2010 provide a natural experiment to evaluate the
Foreign exchange intervention short and medium term objectives of the central bank to contain
Currency intervention excessive exchange rate volatility and to accumulate foreign
Exchange rate volatility reserves respectively. In the low volatility period in the first part of
Reserve accumulation the sample, the central bank is successful in influencing the cur-
Factor model
rency when pressure is to appreciate, accumulating international
Emerging markets
reserves. The same model estimated for the global volatility period
in the second part of the sample shows the central bank inter-
vening to mitigate excessive exchange rate volatility in line with
the short-term objective. The results point to the need to consider
the cross currency market interdependence between emerging
markets when modeling intervention.
2013 Elsevier Ltd. All rights reserved.
1. Introduction
The motives for central banks to intervene in the foreign exchange market include reducing the
economic costs associated with exchange rate volatility which affects international trade, financial
q We are grateful for the useful comments provided by the referee of the paper. Wanaguru acknowledges support from the
Central Bank of Sri Lanka. The views expressed in this paper are those of the authors and do not necessarily represent the views
of the Central Bank of Sri Lanka. McKibbin acknowledges support from ARC Discovery Project DP0985783.
* Corresponding author. Tel.: þ61 2 6125 3387.

E-mail address: renee.mckibbin@anu.edu.au (R.A. Fry-McKibbin).
0261-5606/$ – see front matter 2013 Elsevier Ltd. All rights reserved.
http://dx.doi.org/10.1016/j.jimonfin.2013.05.007
26 R.A. Fry-McKibbin, S. Wanaguru / Journal of International Money and Finance 37 (2013) 25–47
flows, foreign investment and economic growth, and accumulating international reserves to
strengthen a country’s macroeconomic fundamentals (Szakmary and Mathur, 1997; Sarno and Taylor,
2001; Disyatat and Galati, 2007; Pointines and Rajan, 2011). These objectives are particularly important
for emerging markets as they are more prone to and affected by external shocks than their developed
counterparts. Meanwhile, accumulating international reserves helps to establish the confidence of
foreign investors in the domestic economy by positively affecting sovereign risk, and vulnerability to
external shocks can be alleviated through a high level of reserve adequacy (Mulder and Perrelli, 2001;
Dominguez et al., 2011). Using a unique dataset on daily foreign exchange intervention and a new
methodological framework, this paper addresses the effects of intervention on exchange rate volatility
and reserve accumulation for emerging markets using Sri Lanka as an example.1
The officially announced intentions of the Central Bank of Sri Lanka are exactly those mentioned
above but with a time frame associated with each objective in that in the short term, intervention is to
contain excessive volatility in the exchange rate, and in the medium term is to accumulate interna-
tional reserves (Central Bank of Sri Lanka, 2007).2 Determining the effects of intervention for emerging
markets is constrained by data availability and with the exception of Disyatat and Galati (2007) for the
Czech Koruna, there are few published works in this area.3 Sarno and Taylor (2001) and Disyatat and
Galati (2007) provide good surveys to evaluate intervention and its effects on exchange rate volatility
with the conclusions tending to be that intervention can be effective and is conducted mainly in
response to a rapidly appreciating domestic currency. From a reserve accumulation perspective, the
large stocks of reserves held by emerging markets is now attracting attention following the economic
and financial market collapses of the last five years. Important papers examining this issue include
Dominguez et al. (2011) and Dominguez (2010).
A framework which naturally lends itself to modeling central bank foreign exchange intervention
but which has not previously been applied to this topic is the latent factor framework.4 This class of
models is often used to calculate volatility decompositions to decompose financial market asset returns
into specified sources of volatility associated with the factor structure such as global, domestic, asset
market or country factors (Diebold and Nerlove, 1989; Mahieu and Schotman, 1994; Dungey, 1999).
This paper constructs a factor model of intervention for a set of daily currency returns of Sri Lanka and
its major trading partners as well as Sri Lankan intervention data which is modeled endogenously.
The weight placed on the objectives of a central bank’s intervention policy at any point in time is a
function of the prevailing external global economic environment, the domestic economic environment
including policy regime choices, as well as the general level of development of a country. Our model
reflects this environment for an emerging country by specifying each Sri Lankan and trading partner
currency return as a function of global, domestic and intervention factors. The global factor affects all
currency returns in the model but allows each market to respond in different ways. It captures
movements external to the domestic economy and encompasses concepts such as but not exclusively
global market fundamentals, global liquidity conditions and general trader risk aversion. A domestic
factor is specified for each variable and captures movements specific to each market. Intervention is
also a function of global and domestic factors. Using the fact that it is known on which days inter-
vention policy is enacted, an additional intervention factor is specified for the Sri Lankan currency
equation which shares features of the net intervention equation. This relationship exists only on days
on which the central bank intervenes and the feature of known intervention days is also used as part of
the identification of the model.
Events in financial markets in the sample period from January 2002 to December 2010 provide a
natural experiment to evaluate the short and medium term objectives of the Central Bank. The model is
1
We are grateful to the Central Bank of Sri Lanka for providing us with all data, particularly the intervention data.
2
Intervention in Sri Lanka is not aimed at targeting an exchange rate level (Central Bank of Sri Lanka, 2007), implying that
the intervention strategy is to ‘lean against the wind’ to reduce exchange rate volatility.
3
Emerging country central banks and organisations such as the International Monetary Fund aim to fill this gap (Pattanaik
and Sahoo, 2001; Mandeng, 2003; Guimarães and Karacadag, 2004; Herrera and Ozbay, 2005; Kamil, 2008; Adler and Tovar,
2011).
4
The manuscript, Aruman (2003) considers intervention in a latent factor framework but uses a factor structure different to
that adopted here.
R.A. Fry-McKibbin, S. Wanaguru / Journal of International Money and Finance 37 (2013) 25–47 27
estimated over two periods. The first corresponds to the relative calm and low volatility of financial
markets in the first half of the sample, and the second to the period of global volatility associated with
the global financial crisis in the second half. If the commitment to the medium term objective of
reserve accumulation and the short term objective of reducing exchange rate volatility is met, the
volatility decompositions for each period should differ. The data provided distinguishes between days
of intervention through net sales and net purchases of US dollars providing further evidence on the
commitment of the central bank to each objective.
The results suggest that the central bank is successful in achieving its short-term and medium-term
objectives of containing exchange rate volatility and accumulating reserves. In the low volatility period,
the central bank tends to intervene in response to global rather than domestic factors and is able to
influence overall foreign exchange return volatility by 5.5 percent. Splitting the data into days of
intervening through purchases versus sales of US dollars shows that intervention is most effective
when the bank purchases US dollars. This suggests that the central bank is successful in influencing the
exchange rate when the pressure in currency markets is to appreciate the Sri Lankan rupee, hence
accumulating international reserves in line with their medium-term target as is expected during a
period of calm. The same model estimated for the global volatility period presents strikingly different
results. Sales of US dollars is important during this time with the central bank intervening to mitigate
the exchange rate volatility in line with the short-term objective.
The rest of the paper proceeds as follows. Section 2 presents the exchange rate and intervention
data used in the empirical application. The modeling framework is developed in Section 3, and
Section 4 discusses the GMM methodology adopted to estimate the models of intervention. Section 5
presents the empirical results, first focusing on the low volatility period and later the global volatility
period. This section also considers the role of emerging market factors and explores some of the
interdependencies between the regional currency markets on non-intervention compared to inter-
vention days. Section 6 concludes.
2. Exchange rates and intervention
This section presents a preliminary analysis of the data used in the model of foreign exchange
intervention in Sri Lanka. The data comprise of n ¼ 5 daily exchange rate returns of the euro (EURt), the
Indian rupee (INRt), the Japanese yen (JPYt), the British pound (GBPt) and the Sri Lankan rupee (SLRt),
expressed in US dollars, as well as daily net foreign exchange purchases by the Central Bank of Sri Lanka
(INTt). Exchange rate returns are computed by taking the first difference of the natural logarithm of the
exchange rates and multiplying them by 100. Net foreign exchange purchases are in millions of US
dollars. All series are demeaned and scaled by their respective standard deviations, and are expressed
in standardized units. The exchange rates and returns are shown in Fig. 1.5 An increase in the value of
the exchange rate indicates an appreciation of the US dollar against the local currency.
The selection of exchange rates corresponds to Sri Lanka’s main trading partner countries according
to the weights assigned by the Central Bank of Sri Lanka in calculating the 24-currency real effective
exchange rate. The top six countries’ trade weights in the calculation of the real effective exchange rate
are the US (19.74 percent), India (15.57 percent), the UK (9.86 percent), China (6.41 percent), Germany
(5.88 percent) and Japan (4.99 percent).6 The Chinese yuan is excluded from the model as the focus is
on countries with floating exchange rate regimes. The sample consists of a selection of developed-
market exchange rates, as well as the emerging-market exchange rate of the Indian rupee. The
Indian rupee provides a convenient point of comparison with the Sri Lankan rupee in the model.
The intervention data is net foreign exchange purchases data for Sri Lanka as shown in Fig. 2 and is
plotted against the log of the level of the Sri Lankan rupee in panel (a), and the percentage returns in
(b). Positive values of the intervention series represent purchases of US dollars and negative values
5
The outliers in the euro on March 1 and 2, 2005, as depicted in Fig. 1, are removed by regressing the euro returns against a
dummy variable for each outlier.
6
See Box Article 12 of the Central Bank of Sri Lanka Annual Report 2010, Revision of Effective Exchange Rate Indices, http://
www.cbsl.gov.lk/pics_n_docs/10_pub/_docs/efr/annual_report/AR2010/English/9_Chapter_05.pdf (accessed June 5, 2011).
Euro Euro returns

.2 8.0
.1
.0 4.0
-.1
0.0
-.2
-.3 -4.0
-.4
-.5 -8.0
2002
2003
2004
2005
2006
2007
2008
2009
2010
2002
2003
2004
2005
2006
2007
2008
2009
2010
Indian rupee Indian rupee returns
4.0 8.0
3.9
3.9 4.0
3.8
3.8 0.0
3.8
3.7 -4.0
3.7
3.6 -8.0
2002
2003
2004
2005
2006
2007
2008
2009
2010
2002
2003
2004
2005
2006
2007
2008
2009
2010
Japanese yen Japanese yen returns
5.0 8.0
4.9
4.8 4.0
4.7
0.0
4.6
4.5 -4.0
4.4
4.3 -8.0
2002
2003
2004
2005
2006
2007
2008
2009
2010
2002
2003
2004
2005
2006
2007
2008
2009
2010
British pound British pound returns

-.3 8.0
-.4
4.0
-.5
0.0
-.6
-4.0
-.7
-.8 -8.0
2002
2003
2004
2005
2006
2007
2008
2009
2010
2002
2003
2004
2005
2006
2007
2008
2009
2010
Fig. 1. Daily Log Exchange Rates and Percentage Exchange Rate Returns, January 2002–December 2010. Notes: Returns are for the
euro, the Indian rupee, the Japanese yen and the British pound against the US dollar. The shaded area indicates the period of global
volatility from July 2, 2007–December 31, 2010. (Source: Central Bank of Sri Lanka).
4.8 120 1.5 120

4.8 80 1.0 80
0.5 40
4.7 40
0.0
4.7 0 0
-0.5
4.7 -40 -40
-1.0
4.6 -80 -1.5 -80
4.5 -120 -2.0 -120
4.5 -160 -2.5 -160
2002
2003
2004
2005
2006
2007
2008
2009
2010
2002
2003
2004
2005
2006
2007
2008
2009
2010
(a) (b)
SLR/USD exchange rate (log) (left) SLR/USD exchange rate returns (%) (left)
Net foreign exchange intervention USD mn. (right) Net foreign exchange intervention USD mn. (right)
Fig. 2. Sri Lankan Rupee Exchange Rate and Intervention Data, January 2002–December 2010. Notes: Panel (a) is the daily log
exchange rate against the US dollar and net foreign exchange intervention (USD mn). Panel (b) is the percentage daily exchange rate
returns against the US dollar and net foreign exchange intervention (USD mn). The scale on the left of each panel is for the exchange
rate variables and on the right is the intervention data. The shaded areas indicate the period of global volatility from July 2, 2007–
December 31, 2010. (Source: Central Bank of Sri Lanka).
represent sales. Net daily foreign exchange purchases are conducted only in the US dollar market;
however, by doing so, the central bank indirectly influences the exchange rates of other currencies
against the Sri Lankan rupee.
The sample extends from January 1, 2002 to December 31, 2010, and is chosen to begin based on the
availability of the daily foreign exchange intervention data after the floating of the Sri Lankan rupee in
2001. For estimation of the model for the low volatility period in Sections 5.1–5.3, the sample period is
chosen to end on June 29, 2007. The model for the global-volatility period in Section 5.4 is estimated
from July 2, 2007 to December 31, 2010.
The global volatility period is illustrated by the shaded area in the figures. The separation between
the low and global volatility periods is chosen based on reading the minutes and press releases of the
Board of Governors of the Federal Reserve System on the assumption that the trigger for the global
financial market volatility began with the emergence of the US subprime mortgage market distress.
The press release dated June 28, 2007 which is the day prior to the end of the low volatility period
shows that the Fed chose not to change interest rates and did not specifically comment on the vul-
nerabilities to US growth or the financial system at that time (Board of Governors of the Federal Reserve
System, 2007c). The first sign of concern by the Fed about the downside risks to the economy emerged
just over a week later on August 7, followed by the provision of liquidity to financial markets on August
10 (Board of Governors of the Federal Reserve System, 2007a,b). Hence, the beginning of the end of the
low volatility period is chosen to be June 29, the day following the press release on June 28 where no
difficulties were formally flagged to the public.7
Table 1 presents descriptive statistics on the rupee and other exchange rate returns in the model for
the total sample period, as well as for low volatility and global volatility periods for all days, days of
intervention and days on which there is no intervention. Table 2 presents similar statistics for the net
intervention data.8 The central bank does not define the meaning of “excessive volatility” when
7
Conditional structural break tests for a break of unknown timing are also performed for each currency return in a VAR of all
currency returns based on the method of Hansen (2000). The results indicate the structural breaks for each currency return
series are 17 October, 2008 for the euro, 1 September, 2008 for the Indian rupee, 7 March, 2008 for the yen, 17 October 2008 for
the pound, and 12 April, 2007 for the Sri Lankan rupee. All currency returns apart from that for Sri Lanka show a structural
break in 2008 either before or just after the collapse of Lehman brothers. The choice of high volatility period is chosen to be that
corresponding to the subprime period prior to the extreme turmoil leading up to the Lehman brothers collapse as justified by
the anecdotal economic events described.
8
Note that changes in cross rates for example between the Sri Lankan rupee and the euro, are not formally modeled in this
paper, with all exchange rates expressed against the US dollar.
Table 1
Descriptive statistics of the exchange rate returns (percent). Notes: the exchange rates are expressed in terms of US dollars. The
statistics are calculated for each sub-period for all days (All), days on which there is no intervention (Non-int) and days on which
there is intervention (Int). The total sample period is from January 1, 2002–December 31, 2010, the low volatility period is from
January 1, 2002–June 29, 2007, and the global volatility period is from July 2, 2007–December 31, 2010.
Statistics Variable Total sample Low volatility period Global volatility period
All Non-int Int All Non-int Int All Non-int Int

No. of obs. 2171 1089 1082 1324 763 561 847 326 521
Max EUR 7.53 7.53 3.65 7.53 7.53 2.55 3.65 2.99 3.65
INR 3.40 1.93 3.40 1.93 1.93 0.98 3.40 1.74 3.40
JPY 4.41 3.44 4.41 3.44 3.44 1.29 4.41 2.47 4.41
GBP 4.68 2.61 4.68 2.61 2.61 1.47 4.68 2.39 4.68
SLR 1.25 1.15 1.25 1.15 1.15 0.77 1.25 1.14 1.25
Min EUR 6.69 6.69 4.73 6.69 6.69 2.19 4.73 3.80 4.73
INR 3.25 3.25 2.58 2.26 2.26 1.57 3.25 3.25 2.56
JPY 4.73 2.71 4.73 2.71 2.71 2.56 4.73 2.21 4.73
GBP 4.58 2.71 4.58 2.46 2.46 2.08 4.58 2.71 4.58
SLR 2.04 2.04 1.06 2.04 2.04 1.06 1.67 1.67 1.04
Mean EUR 0.02 0.01 0.03 0.03 0.03 0.04 0.00 0.02 0.01
INR 0.00 0.01 0.00 0.01 0.01 0.02 0.01 0.00 0.02
JPY 0.02 0.02 0.06 0.01 0.02 0.04 0.05 0.02 0.09
GBP 0.00 0.01 0.01 0.02 0.02 0.03 0.03 0.01 0.04
SLR 0.01 0.01 0.01 0.01 0.01 0.01 0.00 0.00 0.00
Std. dev. EUR 0.75 0.77 0.73 0.69 0.75 0.59 0.84 0.81 0.85
INR 0.43 0.44 0.42 0.31 0.35 0.24 0.57 0.58 0.56
JPY 0.69 0.64 0.73 0.59 0.61 0.55 0.82 0.72 0.88
GBP 0.69 0.64 0.74 0.56 0.60 0.50 0.86 0.75 0.93
SLR 0.17 0.21 0.14 0.19 0.21 0.15 0.16 0.20 0.12
Skewness EUR 0.359 0.694 0.006 0.589 0.971 0.117 0.202 0.351 0.351
INR 0.272 0.714 0.003 0.538 1.257 0.627 0.219 0.407 0.407
JPY 0.194 0.263 0.128 0.093 0.037 0.394 0.201 0.546 0.546
GBP 0.239 0.041 0.335 0.028 0.030 0.014 0.266 0.099 0.099
SLR 2.088 2.324 1.346 2.332 2.702 1.032 1.404 1.052 1.052
Kurtosis EUR 8.706 10.710 6.594 11.668 15.048 4.393 6.163 5.436 5.436
INR 11.833 10.876 11.790 12.700 12.437 13.086 8.213 7.425 7.425
JPY 6.515 7.365 5.748 6.415 7.252 4.047 5.704 6.717 6.717
GBP 7.563 4.342 8.837 4.481 4.588 4.004 6.870 3.745 3.745
SLR 32.522 29.777 30.738 27.569 28.224 16.972 45.890 34.851 34.851
defining it’s objectives in relation to intervention, hence, there is no formal rule governing when
intervention should occur. However, Fig. 2 and Table 2 show that the Central Bank of Sri Lanka
intervenes frequently. Over the sample period, intervention takes place on approximately 50 percent of
all days, with a fairly even split between net purchases (547 days) and sales (535 days). There is more
intervention in the global volatility period (62 percent of days) compared to the low volatility period
(43 percent of days).
Fig. 2 and Table 2 show that the magnitude of volatility for the intervention data is greater during
the global volatility period. The standard deviation of intervention increased from 7.81 million in the
low volatility period to 20.03 million in the global volatility period. During this time the Central Bank of
Sri Lanka went from being a net seller to a net purchaser as shown by the mean across the sub-periods.
For Sri Lanka, the increased volatility probably results from domestic and external reasons. This period
not only coincides with the global financial crisis, but also the final phase of the 25 year civil war in Sri
Lanka. Turning again to Table 1, on days during the global volatility period when the central bank
intervenes, volatility is higher on intervention days than on days of no intervention for all countries
excluding India and Sri Lanka. For example, on non-intervention days, the standard deviation of the
euro returns is 0.81 percent compared to 0.85 percent on the intervention days, and increases from
0.75 percent to 0.93 percent for the pound. In contrast, the standard deviation for the Sri Lankan rupee
returns falls from 0.20 percent to 0.12 percent perhaps suggesting that the central bank is effective in
containing exchange rate return volatility through intervention when volatility is high, or perhaps
reflecting the improvement of domestic conditions.
Table 2
Descriptive statistics for the intervention data. Notes: the intervention data are expressed in millions of US dollars. The statistics
are calculated for each sub-period on all days there are purchases or sales of US dollars (Intervention), days on which US dollars
are purchased (Purchases) and days on which US dollars are sold (Sales). The total sample is from January 1, 2002–December 31,
2010, the low volatility period is from January 1, 2002–June 29, 2007, and the global volatility period is from July 2, 2007–
December 31, 2010.
Statistics Intervention Purchases Sales

Total sample
No. of obs. 1082 547 535
Mean 0.11 9.71 9.68
Max 99.75 99.75 0.25
Min 118.45 0.25 118.45
Std. dev. 14.99 11.60 11.27
Low volatility period
No. of obs. 561 307 254
Mean 0.35 4.80 6.60
Max 39.15 39.15 0.25
Min 40.00 0.25 40.00
Std. dev. 7.81 4.89 5.89
Global volatility period
No. of obs. 521 240 281
Mean 0.60 16.00 12.47
Max 99.75 99.75 0.25
Min 118.45 0.50 118.45
Std. dev. 20.03 14.36 13.91
The preliminary statistics particularly for skewness in the second panel of Table 1 are also pertinent
to examine. Comparing the skewness statistics for the low and global volatility period for the dataset
shows that the sign of skewness for most currencies are negative in both the low and the global
volatility periods. The striking exception is for the pound sterling return, which during the low vola-
tility period the skewness values are all negative (as are most of the currency returns in the model).
During the global volatility period the sign of skewness for the pound is positive for all types of days. As
shown Harvey and Siddique (2000), risk averse investors prefer positive skewness to negative skew-
ness in asset returns. It is often the case that values of skewness switch signs to become positive during
financial market crises as lower returns are accepted in exchange for positive skewness (Fry et al.,
2010). Only skewness in the sterling responds in this manner, indicating that the sterling is acting as
a safe haven currency in the global volatility period.
It should be noted that foreign exchange intervention in the broad sense includes measures which
affect the exchange rate both directly and indirectly. Intervention from a more narrow perspective is
restricted to purchases or sales of foreign exchange by a monetary authority with a view to influencing
the exchange rate directly. This paper analyzed the narrow perspective of intervention. No stance is
taken on whether intervention here is sterilized or not, although it is probably partially sterilized, as
Canales-Kriljenko (2003) points out, in contrast to developed countries it is not common for central
banks in emerging countries to fully sterilize.
3. Model specification
The analytical framework employed in this paper is a latent factor model of exchange rate
returns in the tradition of Mahieu and Schotman (1994), Diebold and Nerlove (1989) and Dungey
(1999), where exchange rate returns are presented as functions of a set of independent latent
factors. The factors in this application capture movements that are common to all exchange rate
returns (global factors), idiosyncratic to each asset (domestic factors), and related to intervention
(intervention factors). Adopting a factor structure has several advantages. First, the approach
provides a parsimonious representation of the data. Second, observable variables do not have to be
identified or modeled. Third, the approach is convenient to use, as the model implicitly takes into
account all disturbances affecting the system of exchange rate returns. Finally, iid and unit variance
assumptions on the factor structure allow the decomposition of exchange rate returns into the
contribution that each of the factors makes to overall volatility. The volatility decompositions are
the main vehicle for analysis.
In finalizing the factor model of central bank intervention, the model is built up in two stages.
Section 3.1 specifies a factor model of exchange rate returns without formally modeling the effect of
intervention. However, the model distinguishes between non-intervention and intervention days. On
non-intervention days, exchange rate returns are a function of global and domestic factors. On inter-
vention days, the exchange rate returns are a function of the same factors; however, the effect of each
factor on each exchange rate return, as given by the factor loadings, is allowed to change through the
formal modeling of structural breaks. These are designed to capture changes in the global and domestic
dependence structures among the exchange rate returns which may be prevalent on the days that a
central bank chooses to intervene in the foreign exchange market. The modeling of only the exchange
rate returns in the first stage is to provide a sense of these dependence structures before the formal
introduction of intervention.
In the second stage of modeling described in Section 3.2, care is again taken to distinguish between
non-intervention and intervention days. The intervention variable is introduced into the model of ex-
change rate returns and follows the same factor structure as the exchange rates, in that it is specified as a
function of a global and an idiosyncratic factor. However, on intervention days the Sri Lankan rupee
exchange rate returns are allowed to be a function of the idiosyncratic factor associated with the
intervention data, effectively specifying an additional domestic factor (an intervention factor) for the two
Sri Lankan equations on these days. This model is able to provide evidence on the effectiveness of
intervention by the Central Bank of Sri Lanka, as the contribution of intervention to the volatility of the Sri
Lankan exchange rate returns in comparison to the global and idiosyncratic factors is able to be assessed.
3.1. A factor model of exchange rate returns
This section specifies a latent factor model of exchange rate returns for the intervention and non-
intervention days, while suppressing the formal role for intervention. The model consists of n zero
mean daily bilateral exchange rate returns expressed against the US dollar. The data-set is separated
into two parts, which aids identification as outlined in the discussion of the Estimation Method in
Section 4. Let e0t denote the exchange rate returns on non-intervention days (j ¼ 0), and let e1t denote
the exchange rate returns on intervention days (j ¼ 1), such that
n o
j j j j j j
et ¼ EURt ; INRt ; JPYt ; GBPt ; SLRt j ¼ 0; 1: (1)
3.1.1. Non-intervention days

The dynamics of the ith exchange rate returns on non-intervention days (j ¼ 0) is governed by a set
of independent latent factors
e0i;t ¼ li wt þ g0i ui;t i ¼ 1; 2; .; n;

0
j ¼ 0: (2)
The global factor in the model (wt) captures common shocks affecting each of the n exchange rate
returns in the model with their own parameter loading li .9 The domestic factor ui,t captures shocks
0
specific to each currency market, and reflects own-country fundamentals that are independent of
global conditions. The loadings on the idiosyncratic factors are g0i :
3.1.2. Intervention days

On intervention days (j ¼ 1), it is assumed that there is a possibility of higher volatility in the
exchange rate market, perhaps prompting intervention. To allow for this, structural breaks in the factor
9
An alternative structure is to formally model a common numeraire factor to show that all returns are expressed in US
dollars. This factor would affect each exchange rate return with a fixed loading in each equation. The presence of the numeraire
factor imposes a no-arbitrage condition on the model, as shown in Dungey (1999). However, computationally this specification
did not work for this application.
structure are specified for intervention days. The dynamics of exchange rate returns for intervention
days (j ¼ 1) is expressed as

e1i;t ¼ l0i þ l1i wt þ g0i þ g1i ui;t i ¼ 1; 2; .; n; j ¼ 1 (3)
where li and g1i are the structural breaks in the parameters on the global and idiosyncratic factors.
1
In matrix form, the model of exchange rate returns is expressed as
j
et ¼ Lj Ft ; (4)
where for intervention days (j ¼ 1)
2 3 3
l01 þ l11 2
2 3 6 7 0
72 u 3
EUR1t 6 g1 þ g1 0
1
6 7 0 0 0 7 1;t
6 7 6 l0 þ l1 7 6 76
6 INR1t 7 6 2 2 7 6 0 g 0 þ g1 0 0 0 76 u2;t 7
6 7 6 7
7 6 2 2 76 7
6 7 6 0 6 0 76 u 7
¼6 l l 7wt þ 6 7
1
6 JPY1t 7 6 3 þ 3 7 0 0 g þ g1 0 0 7 3;t 7:
6 7 6 7 6 3 3
0 76
6 7
6 17 6 0 7 6 7
4 GBPt 5 6 l4 þ l14 7 6 0 0 0 g4 þ g4
1 0 4
7 4;t 5
u
6 7 4 0 7
SLR1t 4 5 0 0 0 0 g5 þ g15 5 u5;t
l05 þ l15
(5)
3.1.3. Variance decompositions

Using the assumption that the factors are iid(0,1) random variables, Equations (2) and (3) are used to
express the volatility of each of the currency returns into its component factors. For intervention days
the total volatility of each currency return is
h 2 i 2
0 1 2
Var e1i;t ¼ E e1 ¼ li þ li þ g0i þ g1i : (6)
i;t
The proportion of the volatility of the return of exchange rate i when j ¼ 1 explained by the global
factor wt, is
2
l0i þ l1i
2 2 : (7)
l0i þ l1i þ g0i þ g1i
The proportion of the volatility of the return of exchange rate i, explained by the domestic factor ui,t, is
2
g0i þ g1i
2 2 : (8)
l0i þ l1i þ g0i þ g1i
On non-intervention days (j ¼ 0), the variance decompositions are the same, but with the structural
break terms suppressed.
3.2. A factor model of central bank intervention
To examine the effectiveness of central bank intervention, the model in Section 3.1 is extended by
introducing intervention (net purchases of US dollars) as an endogenous variable. The dataset is again
j
separated into the two parts (j ¼ 0,1) of non-intervention vis-à-vis intervention days. Redefining et to
consist of n ¼ 6 series of zero mean bilateral exchange rate returns expressed against the US dollar and
demeaned net intervention in millions of US dollars, the dataset is
n o
j j j j j j j
et ¼ EURt ; INRt ; JPYt ; GBPt ; SLRt ; INTt j ¼ 0; 1: (9)
The model for intervention in the Sri Lankan rupee exchange rate returns market rests on the
assumption that intervention conducted by the Central Bank of Sri Lanka does not directly affect the ex-
change rate returns against the US dollar for the remaining exchange rates in the sample. Hence, the
equations for the exchange rate returns for n ¼ 1,2.0.4 are the same as those stated in Equations (2) and (3).
The new variable intervention ðINTjt Þ; is a function of the global factor wt with parameter loading
lint ; and an idiosyncratic factor vt with loading gjint such that when j ¼ 0
j
INT0t ¼ lint wt þ g0int vt ;

0
(10)
and when j ¼ 1

INT1t ¼ l0int þ l1int wt þ g0int þ g1int vt :
The endogenous treatment of intervention and its inclusion when j ¼ 0 provides a natural test of the
model, as the variation in intervention is expected to be explained only mainly by its own idiosyncratic
factor, with little effect from the global factors.
The equation for the Sri Lankan rupee returns is the same as in Equation (2) for non-intervention
days, but differs from Equation (3) for intervention days where

e15;t ¼ l05 þ l15 wt þ g05 þ g15 u5;t þ s1int vt : (11)
The Sri Lankan rupee returns are now explained by the global factor wt, and two domestic factors.
These are its own domestic factor u5,t and the domestic component of the intervention factor vt. On
intervention days, the factor vt becomes an intervention factor, with the effectiveness of foreign ex-
change intervention by the central bank measured by the loading on the intervention factor in the Sri
Lankan rupee exchange rate returns equation, s1int : Only the domestic intervention factor is included in
the Sri Lankan returns equation on intervention days as the global factor already affects both the Sri
Lankan returns and Sri Lankan intervention decision. Hence the domestic intervention factor repre-
sents pure intervention as the effectiveness of this component of intervention is what the central bank
controls outside of the impact of global shocks.
In matrix form
j
et ¼ Lj Ft ; (12)
and the model of central bank intervention is expressed as
2 3
2 3 6
l01 þ l11 2 0 3
7
EUR1t 6 0 1 7 g1 þ g11 0 0 0 0 0 2
u
3
6 7 6 l þl 7 6 7 1;t
1 6
6 INRt 7 6 2 2 7 6 0 g2 þ g2
0 1 0 0 0 0 76 u 7
6 7 6 7
7 6 76 2;t 7
6 7 6 0 76 7
6 JPY1t 7 6 l03 þ l13 7 6 0 0 g þ g1 0 0 0 76 u3;t 7
6 6
7 ¼6 7 6 3 3 76 7
6 7 7 wt þ 6 76 u 7;
6 GBP1t 7 6 l04 þ l14 7 6 0 0 0 g04 þ g14 0 0 76 4;t 7
6 7 6 7 6 0 7 6 7
6 SLR1 7 6 6 0 1 7
7 6 0 0 0 0 g5 þ g15 s1int 74 u5;t 5
4 t 5 6 7 4 5
6 l5 þ l5 7 0 vt
INT1t 4 5 0 0 0 0 0 gint þ g1int
lint þ lint
0 1
(13)
when j ¼ 1.
3.2.1. Volatility decompositions

Analogous to the factor model of exchange rate returns, the volatility decompositions for the factor
model of central bank intervention is calculated using the expressions for the total variance for each
type of variable
2
0 1 2
Var e1i;t ¼ li þ li þ g0i þ g1i ; i ¼ 1; 2; .; 4
2 2
1 2
Var e15;t ¼ l5 þ l5 þ g05 þ g15 þ s1intv ;
0
(14)
2 2
0 1
Var INT1t ¼ lint þ lint þ g0int þ g1int :
For the Sri Lankan rupee returns, the percentage of the volatility of the returns explained by the
global factor wt is
2
l0i þ l1i
2 2 2 $100: (15)
l0i þ l1i þ g0i þ g1i þ s1intv
The percentage of the volatility of the returns explained by its own domestic factor u5,t is
2
g0i þ g1i
2 2 2 $100: (16)
Finally, the percentage of the volatility of the returns explained by the intervention factor vt is
2
s1int
2 2 2 $100: (17)
In the same manner, the percentage of the volatility of intervention is decomposed into global (wt)
and idiosyncratic (vt) factors, as
2
l0int þ l1int
2 2 $100; (18)
l0int þ l1int þ g0int þ g1int
and
2
g0int þ g1int
2 2 $100; (19)
l0int þ l1int þ g0int þ g1int
respectively.
4. Estimation method
The factor models of exchange rate returns and central bank intervention specified in the previous
section use a GMM estimator, the estimates of which are known to be consistent, asymptotically
normal and efficient (Hansen, 1982). GMM estimation does not require any extra information aside
from that contained in the moment conditions. The estimation involves computing the unknown
parameters by equating the theoretical moments of the model to the empirical moments of the data for
both intervention and non-intervention day regimes in both models.
The model of intervention is identified and estimated by exploiting the feature of the data that inter-
vention did not occur on some days and did occur on others.10 Inspection of Table 1 raises the possibility
that the nature of the distributions on the two types of days (non-intervention versus intervention) across
the low and global volatility period may change. The identification assumptions of the model also allow the
underlying distributions on intervention and non-intervention days to differ as each regime uses the
empirical moment conditions which are specific to the type of day to identify the model regime param-
eters, implicitly capturing any changes in the underlying joint distribution of the dataset on each day.
In the case of the factor model of central bank intervention, which contains n ¼ 6 variables, there are
a total of 42 moment conditions with which to identify 27 parameters by equating the empirical and
theoretical moments of the model. Of the moment conditions, ((6 7)/2) ¼ 21 derive from non-
intervention day data, with the additional 21 derived from intervention day data.
The difference between the empirical moments and the theoretical moments of the model for each
of the (non-intervention and intervention) regimes is
0

M0 ¼ vech U0 vech L0 L0 ; (20)
and
0

M1 ¼ vech U1 vech L1 L1 ; (21)
where Uj refers to the empirical variance-covariance matrices for non-intervention and intervention
0
days, and Lj Lj refers to the corresponding theoretical variance-covariance matrices for the two
j
regimes. The L derives from Equation (12) and uses the assumption that the factors are zero mean and
unit variance, the empirical variance-covariance matrices are
1 X j j0
Uj ¼ ee : (22)
Tj t˛T t t
j
where Tj represents the sample size of non-intervention and intervention day regimes.11
The objective function of the GMM estimator Q accounting jointly for both non-intervention days
and intervention days is minimized according to
Q ¼ M00 W01 M0 þ M10 W11 M1 ; (23)
where Wj are the optimal weighting matrices that correct for heteroskedasticity corresponding to
j ¼ 0,1 (Hamilton, 1994; Newey and West, 1987). All calculations are undertaken using the library
MAXLIK in GAUSS version 11. The GMM estimates are computed by iterating over the parameters and
the weighting matrices using the BFGS algorithm with the gradients computed numerically. Note that
in estimating the model, initial estimates of the variance-covariance matrices are obtained using
identity weighting matrices. That is Wj ¼ I.12
When the number of moment conditions is greater than the dimensions of the parameter vectors,
the model is over-identified. Empirically, an over-identification test can be used to check whether the
model’s moment conditions match the data well or not. Using Hansen’s J-statistic, a test of the over-
identification restrictions is given by
J ¼ TQ ; (24)
10
Dungey et al. (2010) use the regimes of a non-crisis and a crisis period to identify models of contagion in much the same
way that intervention is identified through the two regimes here of non-intervention days and intervention days.
11
Attempts to identify the model described in Section 3 using the variance-covariance matrices of the total dataset is
infeasible, as this would generate only 21 empirical moments to identify 27 parameters in the theoretical model, leaving the
model unidentified.
12
For some variants of the models, the use of optimal weighting matrices were infeasible; thus, for consistency, results using
the identity-weighting matrix for all models are reported.
where T ¼ T0þT1. The minimized distance given in Equation (24) is asymptotically distributed as a c2
with m b degrees of freedom, where m is the number of moment conditions and b is the number of
parameters. A rejection of these restrictions indicates that some variables in the information set fail to
satisfy the orthogonality conditions.
5. Foreign exchange intervention and volatility
This section examines the effect of foreign exchange intervention by estimating the models outlined
in Section 3. The first set of models are estimated for the low volatility period. Before estimating the
fully specified model of central bank intervention in Section 5.2, a model of exchange rate returns
without a formal role for intervention is first estimated in Section 5.1. The role of intervention is
formally introduced in Sections 5.2 and 5.3. Section 5.2 evaluates the effectiveness of intervention in
general, and Section 5.3 evaluates the differences in the effectiveness of intervention when the Central
Bank of Sri Lanka intervenes by purchasing US dollars vis-à-vis when intervention occurs through
sales. The model of central bank intervention distinguishing between purchases and sales is then re-
run over the global volatility sample period in Section 5.4. Finally, Sections 5.5 and 5.6 presents
some robustness analysis, looking at the effects of emerging market interdependence in the context of
currency intervention, as well as the response of central bank intervention when accounting for time
zones and lags in the intervention reaction function.
5.1. A factor model of exchange rate returns
The results of the factor model of exchange rate returns outlined in Section 3.1 are presented in
Table 3. To recap, this model does not formally model intervention, but it does separate the data into
non-intervention days and intervention days. The factor model of exchange rate returns examines the
contribution of the global and domestic factors to overall volatility in exchange rate returns for Sri
Lanka (and the other currencies) on the two types of days. The discussion is framed in terms of the
contribution of each factor to the volatility of each variable in percentage terms as shown in Equations
(15)–(19). The top panel of Table 3 provides the percentage contribution of the global and domestic
factors to overall volatility on non-intervention days. The bottom panel provides the percentage
contribution of the global and domestic factors to overall volatility on intervention days.
The J-test for this model with 10 degrees of freedom is satisfied with a value of 13.481 and a p-value of
0.198. The results provide interesting insights into overall movements in currency markets during the
two regimes. On days when there is no intervention, the Sri Lankan rupee returns are dominated by the
domestic factor with almost 100 percent of volatility arising from purely domestic sources. Table 4
presents the parameter estimates for the factor model along with the p-values. On days when there is
Table 3
Volatility decomposition of the factor model of exchange rate returns. Notes: contribution of each factor to total
volatility, in percent. The model is estimated over the period January 1, 2002–June 29, 2007 (See Equations (7) and
(8)).
Factors
Global Domestic Total

Non-intervention days (j ¼ 0)
EURt 41.983 58.017 100.00
INRt 7.001 92.999 100.00
YENt 41.614 58.386 100.00
GBPt 70.751 29.249 100.00
SLRt 0.245 99.755 100.00
Intervention days (j ¼ 1)
EURt 39.999 60.001 100.00
INRt 25.010 74.990 100.00
YENt 45.028 54.972 100.00
GBPt 53.091 46.909 100.00
SLRt 15.445 84.555 100.00
Table 4
Parameter estimates of the factor model of exchange rate returns. Notes: the model is estimated over the period January 1,
2002–June 29, 2007 (see Equations (2) and (3)). p-values are in parentheses.
Global factors Domestic factors
Parameters Estimates Parameters Estimates

EURt l01 0.646 (0.000) g01 0.760 (0.000)
INRt l02 0.234 (0.000) g02 0.855 (0.000)
JPYt l03 0.668 (0.000) g03 0.791 (0.000)
GBPt l04 0.854 (0.000) g04 0.549 (0.000)
SLRt l05 0.043 (0.460) g05 0.873 (0.000)
EURt l11 0.289 (0.914) g11 0.250 (0.627)
INRt l12 0.093 (0.381) g12 0.016 (0.975)
JPYt l13 0.036 (0.878) g13 0.379 (0.577)
GBPt l14 0.178 (0.358) g14 0.003 (0.986)
SLRt l15 1.185 (0.000) g15 0.087 (0.889)
intervention, the volatility decomposition for Sri Lanka changes substantially. As shown in the bottom
panel of Table 3, on intervention days, the global factor increases in importance from 0.2 percent to
15 percent. This suggests that Sri Lankan policy makers respond to global movements rather than
domestic market movements when intervening in currency markets. Providing further support to this
view is that, on non-intervention days, the only insignificant parameter is the global factor for the Sri
Lankan rupee returns ðl5 Þ. Similarly, on intervention days, the only significant structural break
0
parameter is the global factor for Sri Lanka ðl5 Þ (see Table 3). The analysis in Section 5.2 provides further
1
evidence on whether this is actually the case when intervention is formally introduced into the model.
On both non-intervention and intervention days, the emerging economy of India is most similar to
Sri Lanka, with 93 percent of its volatility a result of domestic factors on non-intervention days. On
intervention days, the weight of the global factor is also larger for India, at 25 percent compared to
7 percent for non-intervention days. Global factors play a larger role for developed countries, with
around 42 percent of volatility for the euro and yen returns, and 71 percent for the pound on non-
intervention days.
5.2. A factor model of central bank intervention
Estimating the factor model of central bank intervention, which adds an equation for intervention
to the factor model of exchange rate returns provides a good overall fit to the data, with the p-value of
the J-test of 0.120. The inclusion of intervention does not change the volatility decomposition too
dramatically as shown by comparing Table 5 and Table 3. The equations for the currency returns in the
factor model of central bank intervention remain the same as those in the factor model of exchange
rate returns for all currencies apart from the Sri Lankan rupee. Inspection of the second panel of the
volatility decomposition in Table 5 shows that the central bank is able to influence the volatility
outcomes by 5.5 percent through intervention which is arguably a substantial magnitude given that the
data is in terms of daily returns. Table 6 reports the results of Wald tests on the joint significance of the
intervention parameters and the intervention terms with all being statistically significant.
Comparing the results from the factor model of exchange rate returns (Table 3) to the model of
central bank intervention (Table 5) for Sri Lanka shows that in both models, global factors contribute
around 16 percent to Sri Lankan rupee return volatility. The intervention factor absorbs some of the
volatility that is attributed to the domestic factor in the previous model. Note that all of the structural
break parameters in the model are jointly significant as shown in Table 6.
The biggest difference in the results for the currency returns between the two models is in the
contribution of the global factor on non-intervention days to the returns of India and Sri Lanka. For
India, the contribution of the global factor rises from 7 percent to 18 percent; for Sri Lanka, it rises from
0.2 percent to 5.5 percent. These increases in magnitude suggest that the inclusion of Sri Lankan central
Table 5
Volatility decomposition of the factor model of Central Bank intervention. Contribution of each factor to total volatility,
in percent. The model is estimated over the period January 1, 2002–June 29, 2007 (see Equation (13)).
Factors
Global Domestic Intervention Total

EURt 44.039 55.961 – 100.00
INRt 18.367 81.633 – 100.00
JPYt 41.741 58.259 – 100.00
GBPt 64.577 35.423 – 100.00
SLRt 5.455 94.545 – 100.00
INTt 0.010 99.990 – 100.00
EURt 37.796 62.204 – 100.00
INRt 30.425 69.575 – 100.00
JPYt 40.812 59.188 – 100.00
GBPt 48.183 51.817 – 100.00
SLRt 16.782 77.697 5.521 100.00
INTt 3.265 96.735 – 100.00
bank intervention means that greater weight is placed on the emerging markets in the global factor in
the model and alludes to similarities between currency movements and the factors driving them for
India and Sri Lanka.
5.3. Purchases versus sales
To further investigate the effectiveness of intervention, the intervention data are split into days
when the Central Bank of Sri Lanka intervenes by purchasing US dollars, and days when intervention
occurs through sales. The model for intervention days is written as

eþ
5;t ¼ l05 þ lþ þ þ þ
5 wt þ g5 þ g5 u5;t þ sint vt ;
0
(25)
where þ denotes days of US dollar purchases, and

e
5;t ¼ l05 þ l
5 wt þ g5 þ g5 u5;t þ sint vt ;
0
(26)
where denotes days of US dollar sales. Hence, the factor model is jointly estimated in three parts rather
than two, and this model again satisfies the J-test with 25 degrees of freedom and a p-value of 0.921.
Table 7 presents the volatility decomposition for the three regimes. The results clearly indicate that
the central bank is more effective on days of US dollar purchases (sales of Sri Lankan rupee), with 11
percent of volatility in the Sri Lankan rupee returns being due to central bank intervention. In contrast,
on days of sales of US dollars (purchases of Sri Lankan rupee), intervention is less effective and explains
only 2 percent of volatility. This suggests that the Central Bank of Sri Lanka is more successful in
Table 6
Wald tests of intervention and structural breaks in the factor model of Central Bank intervention. The model is estimated over
the period January 1, 2002–June 29, 2007 (See Equation (13)).
Hypothesis DOF Test statistic p-value

Joint intervention parameters 2 90.248 0.000
H0 : s1int ¼ g1int ¼ 0
Joint idiosyncratic and intervention parameters 3 69.368 0.000
H0 : g0int ¼ s1int ¼ g1int ¼ 0
Joint structural break parameters 12 2270.097 0.000
H0 : li ¼ g1i ¼ 0; i ¼ 1; 2:::; 6
1
Table 7
Volatility decomposition of the factor model of Central Bank intervention distinguishing between intervention through pur-
chases of US Dollars and Sales of US Dollars. Notes: contribution of each factor to total volatility, in percent. The model is
estimated over the period January 1, 2002–June 29, 2007.
Factors

EURt 44.386 55.614 – 100.00
INRt 18.349 81.651 – 100.00
JPYt 41.547 58.453 – 100.00
GBPt 63.083 36.917 – 100.00
SLRt 5.698 94.302 – 100.00
INTt 0.000 100.000 – 100.00
Days of purchases (j ¼ þ)
EURt 28.033 71.967 – 100.00
INRt 41.976 58.024 – 100.00
JPYt 39.258 60.742 – 100.00
GBPt 39.272 60.728 – 100.00
SLRt 22.183 67.004 10.813 100.00
INTt 2.583 97.417 – 100.00
Days of sales (j ¼ )
EURt 36.253 63.747 – 100.00
INRt 28.499 71.501 – 100.00
JPYt 41.472 58.528 – 100.00
GBPt 0.000 100.000 – 100.00
SLRt 17.225 80.722 2.053 100.00
INTt 4.104 95.896 – 100.00
influencing the exchange rate when the pressure in currency markets is to appreciate the Sri Lankan
rupee. This result is also consistent with the Central Bank of Sri Lanka being focussed on achieving its
medium-term target of accumulating international reserves in the low volatility period. The preliminary
statistics in Table 1 further confirm this as intervention in the low volatility period occurs on days on
which the mean return for the Sri Lankan rupee is positive, while the mean returns of the other cur-
rencies are negative. This implies that Sri Lanka is purchasing other currencies at a low value compared
to their own on these days, hence accumulating reserves in a seemingly strategic manner.
It is worth commenting on the changing role of the Indian rupee in this model. On days when
intervention occurs, through either purchases or sales, the global factor affects Indian rupee returns by
substantially more than on non-intervention days, again alluding to a possible common factor between
India and Sri Lanka.
5.4. Intervention in the global volatility period
The first objective of the central bank is to contain excessive volatility in the exchange rate in the
short run. This objective is examined in this section using the period of global volatility corresponding
to the recent global financial crisis. It is expected that increased volatility in currency markets leads to
more intervention as monetary authorities move to curb some of the volatility. This is verified in Table 1
which presents statistics on intervention during the global volatility period. There are proportionately
more days when intervention took place in the global volatility period, and the standard deviation of
intervention is also higher. Notably, the number of intervention days through sales of US dollars is
higher than the number of days of purchases, suggesting that the central bank aims to prevent excess
currency market volatility arising from negative short-run shocks (or those placing pressure on the
domestic currency to depreciate).
The model in Section 5.3, which distinguishes the effects of intervention through the purchases and
sales of US dollars, is estimated for the period July 2, 2007 to December 31, 2010. The results reinforce
the suggestion that the Central Bank of Sri Lanka is successful in meeting its first objective of containing
excessive currency market volatility in the short run, particularly when pressure is for a rupee
depreciation. Table 8 shows the volatility decomposition corresponding to this period, and it clearly
Table 8
Volatility decomposition of the factor model of Central Bank intervention distinguishing between intervention through pur-
chases of US dollars and sales of US dollars. Notes: contribution to total volatility, in percent. The model is estimated over the
period July 2, 2007–December 31, 2010.
Factors

EURt 79.921 20.079 – 100.00
INRt 12.583 87.417 – 100.00
JPYt 3.641 96.359 – 100.00
GBPt 59.704 40.296 – 100.00
SLRt 3.898 96.102 – 100.00
INTt 4.093 95.907 – 100.00
Days of purchases (j ¼ þ)
EURt 65.314 34.686 – 100.00
INRt 29.451 70.549 – 100.00
JPYt 2.650 97.350 – 100.00
GBPt 51.721 48.279 – 100.00
SLRt 15.384 82.210 2.406 100.00
INTt 0.823 99.177 – 100.00
Days of sales (j ¼ )
EURt 58.055 41.945 – 100.00
INRt 24.616 75.384 – 100.00
JPYt 2.042 97.958 – 100.00
GBPt 0.000 100.000 – 100.00
SLRt 4.170 84.649 11.181 100.00
INTt 3.399 96.601 – 100.00
indicates that central bank intervention is more effective on days of US dollar sales than on days of
purchases, with 11 percent of volatility in Sri Lankan rupee returns due to central bank intervention. In
contrast, on days of purchases, intervention explains only 3 percent of total volatility.
The results for the global volatility period are in contrast to the low volatility period, where pur-
chases of US dollars are more effective than sales. Intervention during the global volatility period on
days of purchases is consistent with the model for the low volatility period, which sees the global factor
increase in importance for overall volatility compared with non-intervention days. On days of US dollar
purchases the global factor does not change by much. Most of the effects of intervention are absorbed
from the domestic factor which falls from around 96 percent of total volatility when there is no
volatility to 85 percent of total volatility on days of purchases.
The asymmetry in the effectiveness of US dollar purchases and US dollar sales of opposite mag-
nitudes in the low and global volatility periods is worthwhile of further investigation, particularly as it
is consistent with the dual objectives of the central bank. To further understand why this asymmetry
emerges, variance equality tests on the exchange rate returns and intervention data are contained in
Table 9. The tests are of the null hypothesis that the variance of currency return (or intervention) i on
days of intervention through purchases is equal to the variance of currency return i on days of inter-
vention through sales, against the alternative that the variances are different. The tests are conducted
for both the low and global volatility periods.
The results of Table 9 are striking and lend further support to the conclusions of the paper. The panel
presenting the results for the low volatility period shows that the null hypothesis of equal variances of
the variables on days of purchases versus sales is rejected for both the Indian and Sri Lankan rupee as
well as for the intervention variable itself. There are no differences in the variances for the euro, yen or
pound on the days of purchases compared to the days of sales.
In stark contrast to the regional differences in the variances in the low volatility period, the vari-
ances of the Indian and Sri Lankan rupees are not significantly different in the global volatility period
on days of purchases compared to days of sales. In fact, the role of the developed markets in the high
volatility period is emphasized as the null hypothesis of no difference in variance is rejected for the
developed countries in the model only. This result is consistent with the switch in policy preference of
the central bank in the global volatility period to reduce currency market volatility.
Table 9
Variance equality tests on the exchange rate returns (percent) and intervention data. The tests are the Bartlett test, the Levene
test and the Brown–Forsythe test. Notes: the null hypothesis is that the variance of currency return i on the days of intervention
through purchases is equal to the variance of currency return i on the days of intervention through sales, against that alternative
that the variances on the days of purchases versus sales are different. The tests are conducted for the low and high volatility
period. The low volatility period is from January 1, 2002–June 29, 2007, and the global volatility period is from July 2, 2007–
December 31, 2010. See Sokal and Rohlf (1995), Levene (1960) and Brown and Forsythe (1974a, 1974b). p-values are in
parentheses.
Low volatility period High volatility period
Bartlett Levene Brown-Forsythe Bartlett Levene Brown-Forsythe

Degrees of freedom 1 (1559) (1559) 1 (1518) (1518)
EURt 1.171 (0.279) 0.706 (0.401) 0.696 (0.405) 28.686 (0.000) 8.947 (0.003) 8.959 (0.003)
INRt 19.018 (0.000) 7.162 (0.008) 7.404 (0.007) 1.466 (0.226) 1.148 (0.285) 1.005 (0.317)
JPYt 0.253 (0.615) 0.067 (0.795) 0.076 (0.782) 16.422 (0.000) 4.802 (0.029) 4.793 (0.029)
GBPt 0.095 (0.757) 0.257 (0.613) 0.220 (0.639) 14.646 (0.000) 4.527 (0.034) 4.453 (0.035)
SLRt 2.860 (0.091) 8.837 (0.003) 8.287 (0.004) 11.460 (0.001) 0.872 (0.351) 0.069 (0.793)
INTt 9.833 (0.002) 7.747 (0.006) 9.332 (0.002) 0.207 (0.649) 1.472 (0.226) 0.986 (0.321)
Although this paper does not to focus in detail on changes to decompositions for the remaining
countries in sample, it is interesting to glean an insight into the global volatility period and the dynamics
of the currency markets during this time. The results differ markedly in terms of decompositions for most
currencies in the model in the global volatility period, particularly for the euro and yen. The global factor
now contributes 80 percent to the euro exchange rate volatility on non-intervention days, reflecting that
the euro US dollar relationship is a key source of volatility. Similarly, the yen is now completely driven by
idiosyncratic factors (96 percent).
An interesting result across all three models is that in both the low and high volatility period, the sterling
exchange rate volatility is determined entirely by domestic factors on days that Sri Lanka intervenes by
selling US dollars. In contrast, on the days of purchases, the contribution of the domestic factor is 60 percent
for the low volatility period, and is 48 percent for the high volatility period. Factor models cannot provide a
strong structural economic interpretation of the reason that a particular factor clusters around one source
of variability, but it can provide some clues. As discussed in Section 2, inspection of the skewness statistics
of Table 1 is indicative of the behavior of investors during the global volatility period, where skewness for
the pound is positive on all types of days, in contrast to the negative sign for all other returns. The sterling is
potentially acting as a safe haven currency in the global volatility period, explaining the loading on the
domestic factor for the pound on days when the central bank is responding to the global economy and
attempting to sell US dollars to restrain the volatility of the Sri Lankan rupee.
5.5. Emerging market interdependence and currency intervention
Modeling the set of currency returns simultaneously raises some potential policy challenges that
central banks particularly in emerging counties may need to consider. One consistent result that has
come through the various model specifications in Section 5 is the seemingly common movements in the
impact of the factor structures for the Indian rupee and Sri Lankan rupee returns. Consistently, on days on
which Sri Lanka intervenes, the global factor contribution to currency market volatility increases for both
countries indicating either a common emerging market factor, or an increase in the role that developed
countries have on the emerging country returns. This occurs in both the low and high volatility periods.
To further investigate the interdependence between the emerging country currency markets both
on days on which Sri Lanka intervenes in the currency market and on days in which it doesn’t, the
model in Equations (2) and (3) are reestimated to also account for a common factor to the emerging
market economies. The model is hence re-specified for India and Sri Lanka so that their currency
returns are also a function of an emerging market factor (dt) with loading ki, i ¼ 2,5. For the non-
intervention days for India (i ¼ 2) and Sri Lanka (i ¼ 5) the equation is
0
e0i;t ¼ li wt þ g0i ui;t þ k0i dt i ¼ 2; 5; j ¼ 0; (27)
Table 10
Volatility decomposition of the factor model of exchange rate returns with an emerging market factor. Notes: Contribution
of each factor to total volatility, in percent. The model is estimated over the period January 1, 2002–June 29, 2007 (see Equations
(27) to (29)).
Factors
Global Domestic Emerging Intervention Total

EURt 41.946 58.054 – 100.00
INRt 16.782 69.222 13.996 – 100.00
JPYt 45.523 54.477 – 100.00
GBPt 49.882 50.118 – 100.00
SLRt 4.371 75.923 19.706 – 100.00
INTt 0.038 99.962 – 100.00
EURt 41.311 58.689 – 100.00
INRt 23.919 30.989 45.092 – 100.00
JPYt 42.530 57.470 – 100.00
GBPt 59.647 40.353 – 100.00
SLRt 9.354 67.722 13.100 9.824 100.00
INTt 2.144 97.856 – 100.00
and for the intervention days (j ¼ 1) for India the equation is

e12;t ¼ l02 þ l12 wt þ g02 þ g12 u2;t þ k02 þ k12 dt ; (28)
and for Sri Lanka

e15;t ¼ l05 þ l15 wt þ g05 þ g15 u5;t þ s1int vt þ k02 dt : (29)
The results of the estimation of this model specification for the low volatility period with inter-
vention are contained in Table 10. Comparison of Table 10 with Table 5 shows that there is evidence of
an emerging market factor between India and Sri Lanka. Inspection of these tables shows firstly that on
non-intervention days, the emerging market common factor contributes 14 percent to the volatility of
the Indian Rupee, and 20 percent to the volatility of the Sri Lankan Rupee. Sri Lanka seems to be
particularly affected by the India-Sri Lanka joint factor on the days of no intervention (j ¼ 0). The
intervention day factor structure also presents evidence of an emerging market factor on these days. It
is potentially important that this factor is comparatively more substantial for India than for Sri Lanka,
with the emerging market factor now contributing 45 percent to the volatility of the Indian rupee on
the days that Sri Lanka intervenes. Comparison of Table 10 with Table 5 shows that the factor structures
are quite similar for the remaining returns across the model. The differences for India and Sri Lanka
actually come mainly from a transfer of the factor loadings from the domestic factors to the emerging
factor rather than from the global factor. However, it is still evident that Sri Lanka is intervening in
response to global rather than emerging market or domestic factors, at least in the low volatility
period.13
The reasons for emerging markets intervening are very different to those of developed countries
and the frequency is also much greater. The results of this paper illustrate the lack of research
undertaken in this area (see Menkhoff, 2012 for a survey of the limited literature) and raise pertinent
questions about interdependence between emerging market currency returns when one country
intervenes. It is the case that emerging markets operate often as competitors and trading partners
13
A similar model was also estimated for the high volatility period with the qualitative results of including an emerging
market factor holding.
Table 11
Volatility decomposition of the factor model of exchange rate returns with an adjustment for time zones. Notes: contribution
of each factor to total volatility, in percent. The model is estimated over the period January 1, 2002–June 29, 2007 (see Equation
(30)).
Factors

EURt 10.930 89.070 – 100.00
INRt 23.981 76.019 – 100.00
JPYt 12.379 87.621 – 100.00
GBPt 6.810 93.190 – 100.00
SLRt 41.932 58.068 – 100.00
INTt 5.015 94.985 – 100.00
EURt 28.651 71.349 – 100.00
INRt 0.415 99.585 – 100.00
JPYt 49.380 50.620 – 100.00
GBPt 0.261 99.739 – 100.00
SLRt 5.549 89.548 4.903 100.00
INTt 0.326 99.674 – 100.00
to each other, and so it is likely that intervention in one market is either not independent from other
emerging markets, or may impact on each other in ways which are not yet investigated.
The results highlight the need of further investigation of cross market intervention effects for emerging
markets in a multivariate model.
5.6. Central bank intervention, time zones and lags in the intervention reaction function
This section presents the results to some sensitivity experiments to determine the robustness of the
model to time zone changes and lags in the intervention reaction function. The five currency markets
considered operate in three major time zones. The European markets are open from 08:00 to 16:30 UMT,
India and Sri Lanka are open from 03:45 to 10:00 UMT, and Japan is open from 0:00 to 6:00 UMT. As all
markets are open for some period of time in the day that the Sri Lankan market is open, this paper chose to use
the contemporaneous currency dataset. However, to determine whether the results are robust to the opening
times of the markets, the markets which close after the Sri Lankan market are lagged one day in model.
The robustness of the model to this feature is assessed by changing the structure of the moments
used to calculate the parameters through the GMM procedure. The empirical variance covariance
matrixes for j ¼ 0,1 in (22) are calculated using
1 X j 0
Uj ¼ ei;t1 ejm;t INTjt eji;t1 ejm;t INTjt i ¼ 1; 3; 4; m ¼ 2; 5 (30)
Tj 1 t˛T
j
instead, with the lagged exchange rates replacing the contemporaneous exchange rates.14
A second exercise was undertaken where we allow for the possibility that the central bank reacts to
previous days returns when deciding to intervene. A second experiment is conducted where the
empirical variance covariance matrixes for j ¼ 0,1 in (22) are calculated using:
1 X j 0
Uj ¼ ei;t1 INTjt eji;t1 INTjt i ¼ 1; 2; .5: (31)
Tj 1 t˛T
j
for all currency returns rather than just those outside of the time zone.
14
Time zone issues relating to the currency pairs under investigation should not be too big of an issue in this model as it is
effectively possible to trade currencies over the entire 24 hour of a day.
Table 12
Volatility decomposition of the factor model of exchange rate returns with an allowance for lags in the intervention reaction
function. Notes: contribution of each factor to total volatility, in percent. The model is estimated over the period January 1,
2002–June 29, 2007 (See Equation (31)).
Factors

EURt 27.495 72.505 – 100.00
INRt 2.501 97.499 – 100.00
JPYt 42.116 57.884 – 100.00
GBPt 0.426 99.574 – 100.00
SLRt 20.004 79.996 – 100.00
INTt 0.000 100.000 – 100.00
EURt 4.385 95.615 – 100.00
INRt 38.130 61.870 – 100.00
JPYt 3.791 96.209 – 100.00
GBPt 17.024 82.976 – 100.00
SLRt 34.916 62.447 2.637 100.00
INTt 5.340 94.660 – 100.00
The results of the two robustness exercises are contained in Tables 11 and 12. Table 11 shows that
the adjustment to the time zones does not qualitatively change the results substantially.15 In contrast,
the results in Table 12 are a little different. The factor structure changes quite a lot particularly for the
Indian rupee, the pound and the Sri Lankan rupee on the non-intervention days, and also for the euro
and the yen on the intervention days. In comparison to other factor models in the literature, we would
expect that the factor loadings for the global factors would be higher than what they are in Table 12 (see
for example Dungey, 1999). The factor loadings in the benchmark models of this paper are more in line
with those in the literature than those in this final robustness experiment.
6. Conclusion
Foreign exchange intervention by central banks in emerging economies has only been studied to a
limited extent, and the effect of such intervention is not well understood. Using a unique dataset and a
new modeling framework, this paper contributed to this literature by estimating a latent factor model
of central bank intervention in a multi-country setting. The case study was for the emerging economy
of Sri Lanka, whose intervention policy objectives are in the short run to contain excessive exchange
rate volatility, and in the medium run to accumulate international reserves.
The factor structure provided a convenient method of identifying sources of currency market
volatility by decomposing the currency returns of Sri Lanka and Sri Lanka’s major trading partners into
a set of factors that included global, domestic and intervention factors. The model was identified using
information on the absence or presence of intervention on a particular day. The moments of the data on
days of no intervention were used to estimate global and domestic factors. The moments of the data on
days of intervention were used to estimate structural change to the factor structure on the days of
intervention, as well as the effect of pure intervention by the central bank. The advantage of latent
factors meant that observable variables did not need to be formally specified. The effectiveness of
intervention was assessed over two periods: i) a period of relatively low volatility in global financial
markets, from January 2002 to June 2007; and ii) a period of high volatility (a global volatility period),
corresponding to the global financial crisis from July 2007 to December 2010. The results were directly
linked to the objectives of the central bank listed above.
The empirical results were supportive of intervention being effective in Sri Lanka over the two pe-
riods, albeit in different ways. The results during both periods showed that the Central Bank of Sri Lanka
15
We also experimented with using rolling two day averages or returns to control for time zones.
responded to global movements in currency markets when they intervened, rather than movements
specific to the domestic foreign exchange market. This suggests that the central bank attempted to
shield the domestic economy from externally sourced fluctuations. In the low volatility period, 11
percent of total volatility was explained by intervention through purchases of US dollars, compared to
two percent of volatility in the case of intervention through sales of US dollars. These findings were
consistent with the medium-term objective of the Central Bank of Sri Lanka of accumulating foreign
exchange reserves, suggesting successful reserves management between 2002 and 2007.
In contrast to the dominance of intervention through purchases relative to sales for the low vola-
tility period, the central bank was focused on mitigating excess currency market volatility arising from
short-run shocks during the global volatility period in the late part of the sample. The variance de-
compositions calculated for 2007 to 2010 clearly showed that eleven percent of Sri Lankan currency
market volatility was explained by sales of US dollars as the central bank attempted to absorb some of
the global turmoil in currency markets through exchange rate management.
Finally, the results indicate that intervention of an emerging market may affect, and be affected by
currency markets of neighboring emerging markets. The evidence here was for regional emerging
market intervention effects, but the results point to the need for a broader investigation of the cross
market effects of the emerging market intervention.
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Journal of International Money and Finance 37 (2013) 25–47

Contents lists available at SciVerse ScienceDirect

Journal of International Money

Currency intervention: A case study

* Corresponding author. Tel.: þ61 2 6125 3387.

2. Exchange rates and intervention

Euro Euro returns

British pound British pound returns

4.8 120 1.5 120

4.5 -120 -2.0 -120

4.5 -160 -2.5 -160

All Non-int Int All Non-int Int All Non-int Int

Statistics Intervention Purchases Sales

3.1. A factor model of exchange rate returns

3.1.1. Non-intervention days

e0i;t ¼ li wt þ g0i ui;t i ¼ 1; 2; .; n;

3.1.2. Intervention days

In matrix form, the model of exchange rate returns is expressed as

where for intervention days (j ¼ 1)

3.1.3. Variance decompositions

3.2. A factor model of central bank intervention

INT0t ¼ lint wt þ g0int vt ;

3.2.1. Volatility decompositions

Q ¼ M00 W01 M0 þ M10 W11 M1 ; (23)

5. Foreign exchange intervention and volatility

5.1. A factor model of exchange rate returns

Global Domestic Total

Global factors Domestic factors

Parameters Estimates Parameters Estimates

5.2. A factor model of central bank intervention

Global Domestic Intervention Total

5.3. Purchases versus sales

where þ denotes days of US dollar purchases, and

Hypothesis DOF Test statistic p-value

Global Domestic Intervention Total

5.4. Intervention in the global volatility period

Global Domestic Intervention Total

Low volatility period High volatility period

Bartlett Levene Brown-Forsythe Bartlett Levene Brown-Forsythe

5.5. Emerging market interdependence and currency intervention

Global Domestic Emerging Intervention Total

and for the intervention days (j ¼ 1) for India the equation is

and for Sri Lanka

Global Domestic Intervention Total

Global Domestic Intervention Total

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