Accumulation of foreign currency reserves and risk-taking

Summary

Focus

Our starting point is to ask if the accumulation of official foreign exchange reserves may have unintended consequences in the form of increased private sector risk-taking. This is a topical question, given the substantial stocks of reserves held by some central banks. We focus on the relationship between the accumulation of reserves and risk-taking in 10 Asia-Pacific economies.

Contribution

We assess whether the accumulation of reserves has systematic effects on private sector risk-taking with an event study analysis using daily data. The event study methodology allows us to consider, without having to specify and estimate time series models, whether changes in reserves holdings influence various proxy measures of risk-taking. Our main proxy measure of risk-taking is the implied volatility of currency options, which can be interpreted as the cost of insuring against exchange rate changes. If the accumulation of reserves leads to an increase in risk-taking, we are likely to see a decline in the cost of insuring against exchange rate changes. Thus the implied volatility of currency options would be systematically associated with changes in reserve holdings.

Findings

We do not find that reserves announcements are systematically associated with changes in risk-taking. Put simply, we cannot reject the null hypothesis that there is no systematic relationship between reserves announcements and risk-taking for any of the economies considered. Thus, our results do not indicate that central banks need to consider unintended risk-taking effects of the accumulation of reserves. We discuss some limitations of our study and suggest possible avenues for future research on the accumulation of reserves and risk-taking.

Abstract

JEL classification: F31, G15

Keywords: foreign exchange reserves; risk-taking; implied volatility; credit default swaps