Intervention Model Nets
JSOM Student a Top Prize
Research with potential to help countries fine-tune their foreign exchange-rate policies has earned a Naveen Jindal School of Management doctoral student a top prize in a student competition sponsored by an international scientific society.
PhD candidate and graduate teaching assistant Sandun Perera recently earned second place from the Financial Services Section of the Institute for Operations Research and the Management Sciences (INFORMS) for his research paper on a new model nations can use to determine the optimal time to enter the foreign-exchange market, the best approach to take in trading and the optimal change to seek in their currencies’ exchange rates.
As detailed in “Market-reaction-adjusted Optimal Central Bank Intervention Policy in a Foreign Exchange Market,” Perera’s model offers better control of market timing and strategy, which, in turn, can affect exchange-rate volatility and decrease expenses associated with a country entering the trading fray.
Bottom line, “the model can save money for a nation’s central bank if implemented properly,” he said.
“It is extremely gratifying to see that the [INFORMS] award was given to a work using advanced mathematical techniques to solve an important real-life problem,” JSOM Professor Alain Bensoussan, one of Perera’s co-authors, said.
Having earned a doctorate in mathematics before coming to UT Dallas, Perera has since become an operations management (OM) scholar. He has used both math and finance skills to study the foreign-exchange market in recent years. However, his interest intensified, he said, following the March 2011 Tōhoku earthquake and tsunami. Afterward, Japan’s central bank sought international support for an intervention to weaken the yen in order help exports.
In dissecting the internal workings of such actions, Perera discovered a major flaw: Earlier intervention models failed to consider exchange-market reaction to central-bank interventions.
“There was empirical evidence to support that there are market reactions,” he says, “but no theoretical models existed to capture the reactions.”
Aided by Bensoussan and JSOM Professor Suresh Sethi and by Florida Atlantic University Associate Professor Hongwei Long — all co-authors of his paper — Perera expanded the knowledge base by incorporating the reactions to create an improved intervention model.
Not up to speed on how this nation-centric trading — a central-bank intervention — works or why it matters? Think of it this way:
The value of a country’s money in circulation — its currency — rises and falls relative to other countries’ currencies in the foreign-exchange market. National governments prefer to keep their currency’s exchange rate comparatively stable — “within a band or close to target rate,” as Sandun Perera’s paper explains.
Why? Because big, frequent or sudden sharp moves up or down can undermine market confidence in a currency and, by extension, its country. A too-strong currency tends to affect exports, making them costlier abroad and hurting their competitive position in world markets. A too-weak currency raises the price of imports, creating inflation at home.
Typically, a national banking authority, such as the Federal Reserve of the United States or the People’s Bank of China, decides if and when to enter the foreign-exchange market. When it does, it buys or sells government reserves of the nation’s cash or of its foreign money, either to devalue or to increase the value of domestic currency.
Though not new, these central-bank interventions have increased in frequency recently. Lately, “world exchange markets see an intervention on the average of once a week,” Perera says.