Informative Trading or Just Noise? An Analysis of Currency Returns, Market Liquidity, and Transaction Costs in Proximity of Central Bank Interventions

Abstract

We study the impact of Central Bank intervention on the process of price formation in currency markets. We use a unique dataset of tick-by-tick indicative quotes posted by dealers on Reuters terminals and of intraday sterilized spot interventions and customer transactions executed on behalf of the Swiss National Bank (SNB) on the Swiss Franc/U.S. Dollar exchange rate (CHFUSD) between 1986 and 1998. We find that potentially informative SNB interventions (but not ex post uninformative customer transactions), although small relative to daily trading volumes in the CHFUSD market, had significant and persistent (albeit asymmetric, depending on their sign) effects on daily currency returns, especially when (relatively) large in magnitude, expected by the market, or inconsistent with existing momentum. The market did not anticipate the occurrence of incoming interventions un-less if chasing the trend. The SNB was much less successful in smoothing fluctuations of the currency, for daily CHFUSD volatility always surged in proximity of interventions, as did average absolute and proportional spreads. Decomposition of estimated absolute spread shocks also reveals that SNB actions induced misinformation among market participants, impacted trading immediacy, and increased market liquidity and competition among dealers. Many of these changes translated into higher transaction costs borne by the population of investors.