RESEARCH PAPER The efficacy of intervention in a chaotic foreign exchange market: an empirical study in INR-USD exchange rate series Chitrakalpa Sen • Gagari Chakrabarti Published online: 21 November 2014 Ó Indian Institute of Management Calcutta 2014 Abstract The traditional method of containing forex volatility is by proper controlling of domestic interest rate and foreign exchange reserves. Such instruments, however, have often failed raising doubts about the efficacy of central bank intervention in forex markets. Recent literature tries to rescue the policy makers by pointing toward the intrinsic dynamics or more specifically, the possible chaotic nature of forex markets and its policy implications. Since volatility is endogenous and no long-run predictions are possible in a chaotic market, traditional methods of interven- tions are likely to fail. This paper explores this issue in context of the Rupee-Dollar exchange rate. It finds that the central bank intervention to be indeed ineffective in an inherently chaotic market. Thus, inefficacy of intervention in forex market could possibly be explained in terms of its intrinsic dynamics. These findings call for a changed policy outlook that could consider the non-linear nature of the forex rates to successfully control its volatility. Keywords Foreign exchange volatility  Central bank intervention  Multivariate GARCH  Chaos Introduction Volatility is one of the best indicators of market risk and refers to the fluctuation of price over a period of time. A period of high volatility has tremendous effect on the economy of the corresponding country and due to increasing financial integration between countries; it also has a massive global effect. A volatile financial market calls for some serious policy changes. At the worst possible case, it might as well trigger a financial crisis. Also, as different economies have different propensities of absorbing volatility, understanding the extent and dynamics of the underlying volatility is of utmost importance. After 1970, most of the countries shifted to floating exchange rate regime. This in turn made the currencies more vulnerable to foreign exchange volatility. A group of economists argued that a volatile exchange rate is detrimental to the countries’ trade scenario (Cushman 1986; Broll 1994; Wolf 1995). Volatility in foreign exchange does not only affect firms with international operations, but it also affects firms with completely domestic operations (Adler and Dumas 1984) through movement of input and output prices as a result of currency volatility. Owing to the great amount of integration between financial markets, volatility in foreign exchange directly affects the stock markets as well. Studies have shown that stock markets respond to volatility in foreign exchange markets. There have been several studies addressing this causal relationship between stock and foreign C. Sen BML Munjal University, Gurgaon, Haryana, India e-mail: chitrakalpa@gmail.com G. Chakrabarti (&) Presidency University, Kolkata, India e-mail: gagari_chakrabarti@yahoo.com 123 Decision (December 2014) 41(4):399–410 DOI 10.1007/s40622-014-0066-9