Strategic Trading When Central Bank Intervention Is Predictable

Abstract

Market prices are noisy signals of economic fundamentals. In a two-period model, we show that if the central bank uses market prices as guidance for intervention, large strategic investors who benefit from high prices would depress market prices to induce a market-supportive intervention. Stronger anticipated interventions lead to deeper price depressions pre-intervention and sharper price reversals post-intervention. The presence of central bank intervention harms strategic investors even though it is the investors who try to mislead the central bank. The model predicts a V-shaped price pattern around central bank interventions, consistent with recent empirical evidence.

Keywords: central bank intervention, strategic trading, price reversal, price volatility

JEL Classification: G14, G18