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

Abstract

We study the impact of sterilized Central Bank interventions on the micro structure of currency markets. We analyze their major channels of effectiveness, 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 such a setting, and consistent with available empirical evidence, we find that intervention has endogenous long-lived effects on quotes when informative about policy objectives and fundamentals, or when the threat of future actions by the Central Bank is significant and credible, for these circumstances lead uninformed investors or dealers to a permanent revision in their beliefs. Portfolio balance effects of such transactions are instead short-lived, because of trading occurring sequentially and not because of high asset substitutability, as often argued in the literature. We also find that a monetary authority attempting to lean against the wind or to chase the trend of the domestic currency is generally more successful when dealers compete against each other for the incoming trades. Intuitively, competition induces the dealers to pass all revenues or losses they expect from trading with the Central Bank onto the population of investors. This is accomplished by greater, and generally asymmetric, revisions of their bid and ask quotes. The resulting equilibrium 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 announced and realized interventions, on the perceived likelihood of a future intervention to occur, and on the transparency of the order flow induced by the intervention.