Exchange rate intervention with options

We consider the problem of a Central Bank that has exchange rate goals. In a partial equilibrium setting, we compare "direct" intervention through sale/purchase of reserves in the currency market with an alternative strategy of intervention with options. The investment bank the Central Bank deals with will have to hedge its position and therefore buy or sell the underlying security (the foreign currency) and bonds. Intervention through options seems to perform better, but the value of the cross-elasticity exchange rate-interest rate is crucial. We provide some grounds for the construction of a full equilibrium model. (C) 2003 Elsevier Science Ltd. All rights reserved.