Usability of central banks in options markets for exchange rate policies

Central Banks intervenes in exchange markets in order to reduce the extreme instability or to prevent the excessive increases and decreases observed in the value of national currency. The high cost of traditional intervention instruments has brought up the use of derived demands of central banks. Mexico and Colombia Central banks have intervened in exchange market by using the option agreement which is a type of derived demand. This study investigates the effects of Columbia Central Bank interventions from 01.12.1999 to 28.12.2012 in the foreign exchange market on the level of exchange rate and on instability in the rates within the framework of E-GARCH model and event-study approach through option agreements, biddings and direct interventions. This paper deals with the Colombia Central Bank interventions in the foreign exchange market as a whole and it also examines the efficiency of option agreements by classifying the types of interventions. In addition to this, whether the types of option used for different aims have a different impact on the level of foreign exchange and instability or not were investigated. The Colombia Central Bank interventions in exchange market were studied via five different models. When the interventions were taken into consideration as a whole, it was found that they affected the level of exchange rate and the instability affirmatively. When the option agreements forming the basis for the study were used as an intervention tool, their reducing effect on the level of foreign exchange rates and instability were observed. Central Banks interventions in foreign exchange market by using the options contracts bring both advantages and disadvantages. If the central banks examine the risks which they may face well and take the necessary measures, it is believed that they can employ the options as a complementary intervention tool in the adequately deepened derived demands. Key Words: Derivatives Markets, Central Banks Interventions, Option Contracts, E-GARCH Analysis, Event-Study Approach.