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Abstract:
We propose a novel theory of the impact of expected, non-secret, 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 construction. In this setting, and consistent with available empirical evidence, we find that the mere likelihood of a future intervention is sufficient to generate endogenous effects on exchange rate levels, to reduce exchange rate volatility, and to impact bid-ask spreads. Intuitively, in the presence of occasional intervention operations, currency dealers (whether monopolistic or perfectly competitive) revise their posted quotes at the beginning of every round of trading for a dual purpose: i) to elicit investors' order flow to take the other side of the potential government trade and ii) to simultaneously reduce its expected magnitude by pushing the exchange rate closer to the announced target level. Quote revisions are generally asymmetric, effectiveness of intervention is greater, and exchange rate volatility is lower under competitive dealership, since the lack of market power induces the dealers to pass any expected additional rent from potential intervention operations to the incoming investors. These effects are either exacerbated or assuaged depending on the extent of the Central Bank's policy trade-off, and either temporary or persistent depending on whether so is the threat of its future actions.
Abstract:
We propose a novel theory of the impact of expected, non-secret, 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 construction. In this setting, and consistent with available empirical evidence, we find that the mere likelihood of a future intervention is sufficient to generate endogenous effects on exchange rate levels, to reduce exchange rate volatility, and to impact bid-ask spreads. Intuitively, in the presence of occasional intervention operations, currency dealers (whether monopolistic or perfectly competitive) revise their posted quotes at the beginning of every round of trading for a dual purpose: i) to elicit investors' order flow to take the other side of the potential government trade and ii) to simultaneously reduce its expected magnitude by pushing the exchange rate closer to the announced target level. Quote revisions are generally asymmetric, effectiveness of intervention is greater, and exchange rate volatility is lower under competitive dealership, since the lack of market power induces the dealers to pass any expected additional rent from potential intervention operations to the incoming investors. These effects are either exacerbated or assuaged depending on the extent of the Central Bank's policy trade-off, and either temporary or persistent depending on whether so is the threat of its future actions.
