Time-Varying Liquidity in Foreign Exchange

This paper addresses whether currency trades have greater price impact during periods of rapid public information flow. Central bankers often suggest that expectations are at times "ripe" for coordinated adjustment, and that periods of rapid information flow are such a time. We develop an optimizing model to account for the joint behavior of order flow and returns around announcements. Using transaction data made available by electronic trading, we estimate the price impact of trades in the DM/$ market precisely. We then test whether trades during periods with macroeconomic announcements have higher price impact. They do. We also test for dependence of liquidity on trading volume and return volatility (two other prominent state variables in the literature on liquidity variation). We do not find any evidence that liquidity depends on these variables. The findings provide policy-makers with guidance for the timing and magnitude intervention.