Long Swings in the US-Dollar: a Stochastic Control Approach.

Since 1973 currency market has been dominated by US-Dollar cycles, the so called long swings. The long swinging behaviour of the dollar has been confirmed also by its strong depreciation against the Euro, registered in the last three years. Periods of steady appreciation followed by period of consistent depreciation causes structural breaks and non linearity in the US-Dollar exchange rate which are not reflected in the standard exchange rate models. The aim of this paper is to use a stochastic control method to describe the US-Dollar dynamic. We assume that the long swings are caused by Monetary Authorities interventions that can affect a set of macroeconomics variables – fundamentals – which follow a stochastic process with state dependent drifts. The drift is the control variable available to the decision makers to prevent the fundamentals to move too far from time varying targets and to influence the long term exchange rate evolution. When the value of the fundamentals is too distant from the specified target, Monetary Authorities interventions trigger the drift of the process to move in the planned direction, shaping a switch from an appreciating cycle to a depreciating one (and vice versa). Solving a system of non linear equations, the switching points of the optimally controlled process are endogenously identified. We also provide a validation of the model, in order to show how it can succeed in detaining all the main switching points.