Market-related Factors Affect Central Bank Interventions in the Foreign Exchange Market
ANN ARBOR, Mich.---The effectiveness of Central Bank (CB) interventions in the foreign exchange market (forex) may be determined by various factors involving competition, information and perceptions.
Successful CB intervention in domestic currency is by no means guaranteed, however, as the U.S. Federal Reserve found in 1987 when purchases of the U.S. dollar were accompanied by its depreciation in a pessimistic market environment. Similarly, during the Asian crisis in 1997 and 1998, the Central Banks of several Asian countries tried unsuccessfully to "lean against the wind" and rescue their ailing exchange rates.
In his doctoral research, Paolo Pasquariello, now an assistant professor of finance at the University of Michigan Business School, uses a stylized model to explore how dealers, investors and an active Central Bank interact in the forex market under various market conditions. His model assumes sequential exchange rate trading with two assets, a domestic- and a foreign-currency riskless bond. Dealer bid and offer quotes are set so that the market is cleared each time by balancing the expected flow of currency bought and sold.
Pasquariello's findings indicate that several key factors can affect the intraday process of price formation and, ultimately, the short- and long-term effects of a targeted CB intervention on the exchange rate. These factors include dealers' market power, the direction and magnitude of the CB intervention, the transparency of the order flow induced by it and the perceived likelihood of future interventions.
Pasquariello reports CB interventions are more successful when dealers must compete with each other for each incoming trade than when they enjoy a monopolistic position.
"Interventions tend to be more effective when dealers' market power is minimal," he said. "When their market power is significant, the market-makers' quest for profit maximization prevents interventions from being fully effective."
The monopolistic dealer, he adds, exploits his market power by charging a higher (or lower) price level, thus making the intervention more (or less) expensive, and reducing its magnitude. Competition, on the other hand, induces the dealers to transfer expected costs and revenues from CB actions fully to investors, thus making quote revisions more substantial.
The direction and magnitude of CB trades also can impact intraday quotes and spreads, according to Pasquariello.
"Small CB trades are more easily accommodated by forex dealers and more easily absorbed by risk-averse investors," he said. "However, small orders do not fully reveal the CB's information advantage and therefore may induce smaller or, if the trades were unexpected, even undesired revisions in beliefs, demands, quotes and spreads."
In addition, Pasquariello says that the speed of adjustment in transaction prices depends on the transparency of the CB's order flow for uninformed investors, who may not know the details of the CB trade and must draw their conclusions based on subsequent changes they observe in dealer quotes.
Market makers, who do observe the direction and size of the CB trade, are able to update their beliefs about the CB's objective, the fundamental value of the currency and the likelihood of intervention and then revise their reservation bid and ask quotes for any future incoming order.
Furthermore, Pasquariello reports, the CB's interventions tend to have persistent effects on quotes when its actions convey information about underlying policy objectives and fundamentals or when the threat of future intervening action is significant and credible. Such circumstances lead otherwise uninformed investors or dealers to permanently revise their beliefs.
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