Toward Removal Of The Swiss Franc Cap: Market Expectations And Verbal Interventions
Swiss National Bank
Swiss Institute of Banking and Finance
Paul Soderlind
University of St. Gallen; Centre for Economic Policy Research (CEPR); University of St. Gallen – School of Finance
July 1, 2016
University of St.Gallen, School of Finance Research Paper No. 2016/14
Abstract:
We ask whether the markets expected the Swiss National Bank (SNB) to discontinue the 1.20 cap on the Swiss franc against the euro in January 2015. In the run-up to the SNB announcement, neither options on the euro/Swiss franc nor FX liquidity indicated a significant shift in market expectations. Furthermore, we find that the SNB’s verbal interventions during the period of cap enforcement increased the credibility of the cap by reducing the uncertainty of future euro/Swiss franc rate. Therefore, we conclude that the markets did not anticipate the discontinuation of the policy.
Toward Removal Of The Swiss Franc Cap: Market Expectations And Verbal Interventions – Introduction
On September 6, 2011, the Swiss National Bank (SNB) set a cap on the Swiss franc’s exchange rate against the euro to avert the risk of deflation resulting from a “massive overvaluation of the Swiss franc,” see SNB (2011). The franc had appreciated significantly against the euro and the US dollar in the months prior to the announcement amid the intensifying euro area crisis. The appreciation posed a threat to the small open Swiss economy. With the policy rate already being at zero, the SNB decided to announce a minimum euro/Swiss Franc exchange rate by promising to buy foreign currency in unlimited quantities if necessary.
Using exchange rate policy to steer monetary conditions at home was not new in Switzerland. For instance, during the years 1977 and 1978, the US dollar depreciated significantly against the Swiss franc. The SNB reacted to the growing signs of recession and deflation caused by the franc appreciation by introducing an exchange rate target of 0.8 Swiss francs for 1 German mark on 1 October 1978. It announced that the Swiss franc exchange rate was to be influenced in such a way that the German mark rate “clearly settles at a level [above] 80 Swiss francs to 100 German marks.”
In principle, a commitment to keeping the domestic currency low is always credible because a central bank can print unlimited amount of its own currency to buy foreign exchange.1 However, as the balance sheet of the central bank grows in size and becomes increasingly volatile, the central bank becomes exposed to various financial risks. Excessive volatility could lead to significant balance sheet losses and even to negative equity positions. As noted by Danthine (2012) and Jordan (2011), this is not a problem in the short term but could generate doubts regarding credibility in the long term.
In this paper, we ask two questions. First, did exchange rate markets understand these risks and expect the discontinuation of the Swiss franc cap? Second, how were the market beliefs affected by central bank verbal interventions and overall conditions on the financial markets?
To analyze the first question, we estimate `market beliefs’ from option prices on the euro/Swiss franc exchange rate and market liquidity from the bid-ask spreads of various currency pairs with the Swiss franc – and study the dynamics of the two in the run-up to January 15, 2015. The evidence suggests that the exchange rate market did not anticipate the discontinuation of the cap.
We study the second question by regressing the market beliefs during the period of the cap on the SNB’s verbal interventions and a variety of financial market indicators. We consider a verbal intervention to be a speech made by a member of the SNB Governing Board that contained the wording “utmost determination” and/or “unlimited quantities” when discussing the Swiss franc cap. We show that these verbal interventions significantly reduced perceived uncertainty of the future euro/Swiss franc rate.
Several other papers study the SNB’s exchange rate policy over this period. Hertrich and Zimmermann (2015) explore the credibility of the Swiss franc cap and find that the cap was never perfectly credible, as the estimated probability of the euro/Swiss franc exchange rate being below 1.20 was high. Hanke et al. (2015) and Jermann (2016) report increasingly lower estimates of the break probability and conclude that the market’s confidence in the SNB’s commitment increased over time, especially from late-2012 until the end of their samples. We contribute to this literature by providing evidence on (a) whether the option-implied distributions can be explained by central bank actions and measures of financial market uncertainty, and (b) the liquidity patterns around the discontinuation of the cap.
Our study also touches upon a large literature on central banks’ verbal interventions in the foreign exchange market. Jansen and De Haan (2005) study the reaction of the conditional mean and volatility of the euro/US dollar exchange rate to statements by European Central Bank (ECB) officials and conclude that those statements mainly influenced the conditional volatility. Similarly, Beine et al. (2009) show that issuing commentary statements during foreign exchange interventions tends to reduce exchange rate volatility. Fratzscher (2008) finds that communication policies by the central banks of the US, euro area and Japan have generally constituted an effective policy tool in influencing exchange rates in the desired direction.
The reminder of the paper is organized as follows. In section 2, we introduce the dataset. Section 3 lays out the methodology, and section 4 reports our findings.
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