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Description
AN EXTENSIVE BODY of research in open economy macroeconomics has examined the impact of central bank interventions on exchange rate dynamics. Traditional explanations rely on fundamentals and rational expectations models of exchange rate determination to examine the effects of central bank interventions (Dominguez and Frankel 1983a, 1983b, 1983c). (1) Sterilized interventions can affect exchange rates through two theoretical channels--the "portfolio balance" channel and the "signaling channel." According to the portfolio balance channel, sterilized interventions affect exchange rates by changing the currency denomination of the supplies of different assets held by investors. Alternatively, sterilized interventions can signal future money supply or interest rate changes, thereby affecting the current value of the exchange rate. Empirically, however, both channels have received limited or ambiguous support in studies that use data at daily or weekly frequencies (Edison 1993, Dominguez and Frankel 1993a, 1993c, Humpage 1999).
A more recent strand of the literature investigates the market microstructure effects of central bank interventions (Peiers 1997, Naranjo and Nirmalendran 2000, Evans and Lyons 2003a, Dominguez 2003). Empirical market microstructure research notes that the failure of previous work to identify the impact of central bank interventions on exchange rates may stem from a lack of statistical power in studies that use data at more aggregated frequencies--a shortcoming that may be resolved by using higher frequency data (Evans and Lyons 2002, 2003b). In particular, a drawback with using aggregate data at daily or weekly frequencies is that the empirical estimations fail to unravel mechanisms by which market participants assimilate information about interventions. Intra-day or high-frequency data, on the other hand, allow the researcher to more precisely examine the mechanism through which the central bank intervention signals are transmitted to individual market participants and ultimately impact the aggregate exchange rate.
This article examines individual bank responses to the central bank interventions in foreign exchange markets. I use intra-day tick-by-tick data from the yen/dollar market to study inter-bank bid--ask quote revisions in response to news of central bank intervention to ask following questions. First, does intervention activity create asymmetric information or increased inventory carrying costs among traders, as evidenced by increased inter-bank bid--ask spreads? (2) Second, is there cross-sectional variation in the bid--ask spread changes quoted by individual banks when the central bank intervenes?
Microstructure models of central bank interventions predict that the degree of heterogeneity in trader beliefs about both spot rate fundamentals and the intervention signal affect the market's reaction to central bank intervention (Bhattacharya and Weller 1997, Vitale 1999). Specifically, central banks play a role akin to that of liquidity traders in standard microstructure models (Kyle 1985). Analogous to liquidity traders, central banks represent a source of demand that can be independent of the underlying fundamental value of the spot exchange rate. The potential independence of central bank trading from spot rate fundamentals makes the central bank's order flow a noisier signal of the target exchange rate.
Furthermore, recent evidence suggests that investor heterogeneity might play a key role in explaining exchange rate fluctuations. In particular, Evans and Lyons (2002) show that most short-run exchange rate volatility is related to order flow, which in turn is associated with heterogenous investors) The theoretical premise in this article is that individual trader signals about the fundamentals and the intervention signal combine to determine price responses in the inter-bank market for foreign exchange (Bhattacharya and Weller 1997, Vitale 1999). If an intervention announcement creates uncertainty among traders about future monetary policy or other fundamentals and hence the future spot rate, then volatility will increase and bid--ask spreads will widen in the spot market for foreign exchange. Conversely, volatility will fall and bid-ask spreads narrow if the central bank's signal reduces uncertainty about the short-run variability about the target exchange rate. Analyzing individual bank price responses to interventions may therefore allow for a better understanding of the aggregate market response to intervention episodes.
The data set used in the article contain 0.56 million yen/dollar spot rate quotes distinguished by 125 banks in the inter--bank market for foreign exchange. The empirical analysis combines tick-by-tick spot rate data with time-stamped Reuters reports to examine the impact of central bank order on the quote behavior of individual banks. Since the database includes market survey expectations from the Reuters FXNB page, the model distinguishes between anticipated and unanticipated intervention. Time-stamped news items verify the timing of intervention events and the direction of the interventions.
The sample period covers the period between October 1, 1992 and September 30, 1993. During this period, there were 71 announcement dates when news of Bank of Japan (BOJ) and the Federal Reserve intervention activity in the yen/dollar market was reported by Reuters. Since the distribution of the bid--ask spreads is discrete, an ordered probit model in an event study framework is used to correlate intervention news to movements in the spread. The results are disaggregated by individual bank traders to study the price responses of the top bank traders in the yen/dollar market following central bank interventions. The top 20 banks account for over 65% of total quote activity in the yen/dollar market.
My main findings are as follows. First, aggregate market uncertainty increases following central bank trading activity. (4) The estimations show that central bank interventions lead to a statistically significant increase in spot rate volatility and wider bid-ask spreads in the spot market for foreign exchange. The results, using high-frequency data, are therefore consistent with Naranjo and Nirmalendran (2000) who document an increase in aggregate bid--ask spreads using daily data. In addition, the estimations provide marginal effects from the ordered probit model to evaluate the economic significance of shifts in the bid--ask spread distribution conditional on news of central bank intervention. The estimates show that if the probability of an intervention by the Federal Reserve increases by one standard deviation, the probability of observing a bid--ask spread of less than 10 basis points falls by 8.14% while the probability of observing a bid--ask spread greater than or equal to 10 basis points rises by 7.8%. Marginal effect estimates for increases in the volatility of the spot rate also result in an increase in bid--ask spreads. Extending the estimation procedure to account for an irregular quote arrival pattern reveals that spreads widen during periods of infrequent trading activity.
Second, individual bank estimates from the top 10 banks with the most quotes following the arrival of news about central bank activity show dispersion in the bid-ask spreads posted by individual banks. The results provide evidence that the aggregate market reaction of wider bid--ask spreads reflects the increase in bid--ask spreads posted by a subset of individual banks when central banks intervene. Marginal effects estimates show that the probability of bid--ask spreads increasing to the third-highest category of 10 basis points or higher increases significantly for Banca Commericale Italiana, Chemical Bank, and the Industrial BOJ when the Federal Reserve intervenes and Dai-Ichi Kangyo Bank, Dresdner Bank, and Morgan Guaranty when the BOJ intervenes. Notably, Tokai Bank and the Industrial Bank of Japan post narrower spreads when the BOJ intervenes. The posted spreads for some banks in the top 10 remain unaltered in response to central bank interventions. The aggregate market response--increased spot rate volatility and wider bid--ask spreads--therefore represents a cumulative reaction made up of the disaggregated responses from individual banks.
Comparing responses across BOJ and Federal Reserve interventions also suggests that there is cross-sectional variation in individual bank responses depending on which central bank intervenes. The finding is consistent with the fact that the lineup of banks in the top 10 changes depending on the identity of the intervening central bank. The cross-sectional dispersion in bid--ask spread revisions may point to differences in the magnitude of inventory problems faced by individual banks when a central bank intervenes.
The results in this article contribute to the evidence in studies that examine market microstructure effects of macro-announcements in general and central bank interventions in particular. For example, Ederington and Lee (1993) and Anderson et al. (2003) note that the arrival of public information induces abrupt price changes, and that the average price move is typically attained within minutes. Yet, volatility and trading volume tend to remain elevated for several hours. If agents have identical information sets and interpret news similarly, the protracted response pattern is hard to explain and provides an argument in favor of models with heterogeneously informed agents. Analyzing individual bank responses to the arrival of public news, such as interventions provides a step in this direction.
For example, Peiers (1997) identifies price leadership patterns in foreign exchange trading, with Bundesbank interventions as an informational trigger. Granger-causality regressions for a cross-section of individual-bank quotes suggest transitory price leadership by Deutsche Bank between 60 and 25 minutes before Bundesbank intervention reports. The results provide evidence of information asymmetries across individual bank participants in the foreign exchange market surrounding the release of intervention news.
Furthermore, price adjustments will eventually reflect information-based order flows (Kyle 1985). In this article, I examine bid--ask spread revisions posted by individual banks in response to intervention reports. Bid--ask spreads represent order processing, inventory, and adverse selection costs in the foreign exchange market. When a central bank intervenes, increases in posted bid--ask spreads provide information about increased asymmetric information risk, as well as inventory risk. The cross-sectional dispersion in the quotes posted supply disaggregated information about how different market participants respond to central bank intervention signals.
In addition, using intra-daily data, Dominguez (2003) and Chang and Taylor (1998) show that aggregate market volatility is higher on intervention days in comparison to days where the central bank does not enter the foreign exchange market. The evidence in this article confirms the finding that intervention days are accompanied by greater market volatility. Related papers that use intra-day data to study central bank interventions include Goodhart and Hesse (1993) who show that interventions have no short-term or systematic effect on returns in the foreign exchange market. Payne and Vitale (2003) use exchange rate data sampled at 15-minute intervals to quantify the effects of intervention operations on the U.S. dollar/Swiss franc (USD/CHF) rate.
Other studies that have examined bid--ask spreads in the foreign exchange market include Naranjo and Nirmalendran (2000) who use daily bid--ask spreads in the DM/dollar market to argue that uncertainty surrounding the unexpected component of central bank interventions may induce dealers to increase their spreads because of adverse selection considerations. The results in this article complement these findings using high-frequency data. Pasquariello (2005) provides a theoretical rationale for interventions to affect bid--ask spreads through their impact on dealers' inventories and shows that the aggregate market spreads for the USD/CHF increase during intervention event windows. This article takes the analysis one step further by examining bank-level quotes to disaggregate the responses of individual banks when a central bank intervention takes place. The disaggregated individual bank results bring a piece of evidence to bear on the existing literature by providing a look inside the "black box" of the aggregate market response to central bank intervention in the foreign exchange market.
The article proceeds as follows. Section 1 presents a brief theoretical motivation for asymmetric information frameworks where the central bank is the strategic "informed insider." Section 2 describes the data. Section 3 outlines the empirical methodology employed and discusses the results from the analysis. Section 4 presents additional tests and robustness checks. Section 5 concludes.
1. ASYMMETRIC INFORMATION, CENTRAL BANKS, AND INDIVIDUAL BANK TRADERS
Models with asymmetric information and heterogeneous agents from the market microstructure literature can be used to motivate the signaling explanation of central bank interventions. Microstructure models with a strategic informed insider (such as Bhattacharya and Weller 1997) assume that central banks are informed insiders since they have an informational advantage about spot rate fundamentals. In particular, these models assume that central banks have inside information about the course of future monetary policy. Further, central bank utility functions differ from standard profit maximizing agents since central banks can choose to make losses on their intervention operations by leaning against the wind. In doing so, central banks weigh the expected loss on currency transactions against their success in achieving targeting objectives or reducing exchange rate volatility. However, rational speculators (in our case individual banks) in the foreign exchange market also have private information with respect to central bank objectives. Therefore, a combination of asymmetric information and Bayesian learning can be used to model central bank interventions functioning as signals that communicate information about future monetary policy and the fundamentals process underlying the spot rate.
Specifically, microstructure models identify two conditions under which information may differ across participants in the foreign exchange market when the central bank intervenes (Kyle 1985, Bhattacharya and Speigel 1991). First, central banks and bank traders as a group can differ in their interpretation of the fundamentals. Second, individual traders' private signals about the fundamentals may differ across traders. (5) These two effects can lead to an increase in market uncertainty if the target spot rate implied... |
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