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Central bank intervention and the intraday process of price formation in the currency markets

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  • Pasquariello, Paolo

Abstract

We propose a novel theory of the impact of sterilized spot interventions on the microstructure of currency markets that focuses on their liquidity. We analyze the effectiveness of intervention operations in a model of sequential trading in which i) a rational Central Bank faces a trade-off between policy motives and wealth maximization; ii) currency dealers' sole objective is to provide immediacy at a cost while maintaining a driftless expected foreign currency position; and iii) adverse selection, inventory, signaling, and portfolio balance considerations are absent by assumption. In this setting, and consistent with available empirical evidence, we find that i) the mere likelihood of a future intervention--even if expected, non-secret, and uninformative--is sufficient to generate endogenous effects on exchange rate levels, to increase exchange rate volatility, and to impact bid-ask spreads; and ii) these effects are exacerbated by the intensity of dealership competition, the extent of the Central Bank's policy trade-off, and the credibility of its threat of future actions.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of International Money and Finance.

Volume (Year): 29 (2010)
Issue (Month): 6 (October)
Pages: 1045-1061

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Handle: RePEc:eee:jimfin:v:29:y:2010:i:6:p:1045-1061

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Web page: http://www.elsevier.com/locate/inca/30443

Related research

Keywords: Foreign exchange Central bank intervention Market microstructure Liquidity Volatility Bid-ask spread;

References

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Citations

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Cited by:
  1. Scalia, Antonio, 2008. "Is foreign exchange intervention effective? Some microanalytical evidence from the Czech Republic," Journal of International Money and Finance, Elsevier, vol. 27(4), pages 529-546, June.
  2. Michael R. King & Carol Osler & Dagfinn Rime, 2013. "The market microstructure approach to foreign exchange - Looking back and looking forward," Working Paper 2013/12, Norges Bank.
  3. Kathryn M. E. Dominguez & Freyan Panthaki, 2007. "The influence of actual and unrequited interventions," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 12(2), pages 171-200.
  4. Pasquariello, Paolo, 2007. "Informative trading or just costly noise? An analysis of Central Bank interventions," Journal of Financial Markets, Elsevier, vol. 10(2), pages 107-143, May.
  5. Dominguez, Kathryn M. E., 2003. "The market microstructure of central bank intervention," Journal of International Economics, Elsevier, vol. 59(1), pages 25-45, January.
  6. Kathryn M.E. Dominguez, 2003. "When Do Central Bank Interventions Influence Intra-Daily and Longer-Term Exchange Rate Movements?," NBER Working Papers 9875, National Bureau of Economic Research, Inc.
  7. Charles Engel, 2013. "Exchange Rates and Interest Parity," NBER Working Papers 19336, National Bureau of Economic Research, Inc.
  8. Carpenter, Andrew & Wang, Jianxin, 2007. "Herding and the information content of trades in the Australian dollar market," Pacific-Basin Finance Journal, Elsevier, vol. 15(2), pages 173-194, April.
  9. Michael R. King & Rasmus Fatum, 2005. "The Effectiveness of Official Foreign Exchange Intervention in a Small Open Economy: The Case of the Canadian Dollar," Working Papers 05-21, Bank of Canada.

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