Intervention and the Risk Premium in Foreign Exchange Rates

The shift from a fixed-exchange-rate regime to a flexible regime, in which central-bank exchange-market intervention has been highly visible, has renewed interest in studying the effects of intervention. In separate work started by Engle (1982), new techniques have been developed to analyze risk premia in asset returns and particularly in exchange rates. We utilize a framework developed by Hodrick (1989) to show how central-bank intervention can affect both the level of exchange rates and the risk premium. We assume specific foms for preferences and for the stochastic processes of the exogenous variables and show how the risk premium is related to the conditional variances of intervention and the other exogenous processes. This approach differs from previous analyses of intervention by explicitly relating intervention to the risk premium. This lays the groundwork for future tests of the theory’s implications for the intervention/risk premium relationship.