Central Bank Intervention and the Intraday Process of Price Formation in the Currency Markets

55 Pages Posted: 11 Nov 2008

See all articles by Paolo Pasquariello

Paolo Pasquariello

University of Michigan, Stephen M. Ross School of Business

Multiple version iconThere are 3 versions of this paper

Date Written: October 2002

Abstract

We study the impact of Central Bank intervention on the microstructure of currency markets. We analyze the two major channels of effectiveness of currency management policies, imperfect substitutability and signaling, in a model of sequential trading in which the stylized monetary authority is a rational but not necessarily profit-maximizing player. In the context of our model and consistently with the available empirical literature, intervention has long-lived effects on quotes when informative about policy objectives and economic fundamentals, or when the threat of future government action is significant and credible. A monetary authority attempting to lean against the wind or to chase the trend of the domestic currency is more successful when dealers compete against each other for the incoming trades. The resulting process of intraday price formation and bid-ask spreads are shown to depend crucially on the degree of market power held by the forex dealers, on the sign and magnitude of the announced and realized intervention, on the perceived likelihood of a future intervention to occur, on the transparency of the order flow induced by the intervention, on the direction and heterogeneity of agents' beliefs and expectations, and on the elasticity of risk-averse investors' demand for foreign currency-denominated assets.

Suggested Citation

Pasquariello, Paolo, Central Bank Intervention and the Intraday Process of Price Formation in the Currency Markets (October 2002). NYU Working Paper No. S-FI-02-10, Available at SSRN: https://ssrn.com/abstract=1298827

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