The Effect of Capital Controls and Prudential FX Measures on Options-Implied Exchange Rate Stability
48 Pages Posted: 9 Apr 2013
Date Written: March 8, 2013
Has the recent wave of capital controls and prudential FX measures been effective in promoting exchange rate stability? We tackle this question by studying a panel of 25 countries/currencies from July 1st , 2009 to June 30, 2011. We calculate daily measures of exchange rate volatility, absolute crash risk, and tail risk implied in currency option prices and we construct indices of capital controls and prudential FX measures taking into account the exact date in which policy changes are implemented. Using a difference-in-differences approach, we find evidence that: (i) exchange rate stability gains from the tightening of controls on nonresidents are illusive, the suppression of daily exchange rate fluctuations comes at the cost of increasing likelihood of currency crisis, with no clear benefits for absolute crash risk; (ii) the easing of controls on residents truly improves exchange rate stability over all dimensions; and (iii) the tightening prudential FX measures not specific to derivative markets reduces absolute crash risk and tail risk, with no effect on volatility.
Keywords: Exchange Rates, Volatility, Crash and Tail Risk, Currency Options, Capital Controls, Prudential Measures
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