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

We study the impact of Central Bank intervention on the microstructure of currency markets. We analyze the two major channels of effectiveness of currency management policies, 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 the context of our model and consistently with the available empirical literature, intervention has long-lived effects on quotes when informative about policy objectives and economic fundamentals, or when the threat of future government action is significant and credible. A monetary authority attempting to lean against the wind or to chase the trend of the domestic currency is more successful when dealers compete against each other for the incoming trades. The resulting 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 the announced and realized intervention, on the perceived likelihood of a future intervention to occur, on the transparency of the order flow induced by the intervention, on the direction and heterogeneity of agents' beliefs and expectations, and on the elasticity of risk-averse investors' demand for foreign currency-denominated assets

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

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

Government Intervention and Arbitrage

We model and document the novel notion that direct government intervention in a market may induce violations of the law of one price (LOP) in other, arbitrage-related markets. We show that the introduction of a government pursuing a non-public, partially informative price target in a model of strategic trading and segmented dealership generates equilibrium price differentials among fundamentally identical (or linearly related) assets -- especially when markets are illiquid, LOP violations are small, speculators are heterogeneously informed, or policy uncertainty is high. We find supportive evidence in a sample of ADRs traded in U.S. exchanges and currency interventions by developed and emerging countries between 1980 and 2009.https://deepblue.lib.umich.edu/bitstream/2027.42/107444/13/1240_Pasquariello_May2017.pdfhttps://deepblue.lib.umich.edu/bitstream/2027.42/107444/10/Pasquariello-March2017.pdfhttps://deepblue.lib.umich.edu/bitstream/2027.42/107444/8/1240_Pasquariello_May2016.pdfhttps://deepblue.lib.umich.edu/bitstream/2027.42/107444/6/1240_ Pasquariello_June2015_2.pdfhttps://deepblue.lib.umich.edu/bitstream/2027.42/107444/4/1240_ Pasquariello_June2015.pdfhttps://deepblue.lib.umich.edu/bitstream/2027.42/107444/1/1240_Pasquariello.pdfDescription of 1240_Pasquariello_May2017.pdf : May 2017 revisionDescription of 1240_Pasquariello_May2016.pdf : SUPERSEDED: May 2016 RevisionDescription of 1240_ Pasquariello_June2015_2.pdf : SUPERSEDED: June 2015 Revision (newer)Description of 1240_ Pasquariello_June2015.pdf : SUPERSEDED: June 2015 RevisionDescription of 1240_Pasquariello.pdf : SUPERSEDED: Original versionDescription of 1240_Pasquariello_May2017.pdf : May 2017 revision

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

We study the impact of Central Bank intervention on the microstructure of currency markets. We analyze the two major channels of effectiveness of currency management policies, 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 the context of our model and consistently with the available empirical literature, intervention has long-lived effects on quotes when informative about policy objectives and economic fundamentals, or when the threat of future government action is significant and credible. A monetary authority attempting to lean against the wind or to chase the trend of the domestic currency is more successful when dealers compete against each other for the incoming trades. The resulting 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 the announced and realized intervention, on the perceived likelihood of a future intervention to occur, on the transparency of the order flow induced by the intervention, on the direction and heterogeneity of agents' beliefs and expectations, and on the elasticity of risk-averse investors' demand for foreign currency-denominated assets

Agency Costs and Strategic Speculation in the U.S. Stock Market

This study shows theoretically and empirically that a firm's agency problems may affect its stock liquidity. We postulate that less uncertainty about suboptimal managerial effort may enhance liquidity provision -- by lowering dealers' perceived adverse selection risk from trading with better-informed speculators. Consistent with our theory, we find that the staggered adoption of antitakeover provisions across U.S. states in the 1980s and 1990s -- a plausibly exogenous shock reducing perceived effort uncertainty by unambiguously facilitating managerial agency -- improves the stock liquidity of affected firms relative to peer firms. This evidence suggests that firm-level agency considerations play a nontrivial role for the process of price formation in financial markets.http://deepblue.lib.umich.edu/bitstream/2027.42/113259/1/1284_Pasquariello.pdfhttp://deepblue.lib.umich.edu/bitstream/2027.42/113259/4/1284_Pasquariello_Jan2016.pdfhttp://deepblue.lib.umich.edu/bitstream/2027.42/113259/6/1284_Pasquariello_May2016.pdfhttp://deepblue.lib.umich.edu/bitstream/2027.42/113259/8/1284_Pasquariello_Nov2016.pdfDescription of 1284_Pasquariello_May2016.pdf : May 2016 RevisionDescription of 1284_Pasquariello_Jan2016.pdf : January 2016 revisionDescription of 1284_Pasquariello_Nov2016.pdf : November 2016 revisio

Political Uncertainty and Financial Market Quality

We examine the effects of political uncertainty surrounding the outcome of U.S. presidential elections on financial market quality. We postulate those effects to depend on a positive relation between political uncertainty and information asymmetry among investors, ambiguity about the quality of their information, or dispersion of their beliefs. We find that market quality deteriorates (trading volume and various measures of liquidity decrease) in the months leading up to those elections (when political uncertainty is likely highest), but it improves (trading volume and liquidity increase) in the months afterwards. These effects are more pronounced for more uncertain elections and more speculative, difficult-to-value stocks (small, high book-to-market, low beta, traded on NASDAQ, or in less politically sensitive industries), but not for direct proxies of the market-wide extent of information asymmetry and heterogeneity among market participants (accruals, analysts' forecast dispersion, and forecast error). These findings provide the strongest support for the predictions of the ambiguity hypothesis.http://deepblue.lib.umich.edu/bitstream/2027.42/106538/1/1232_Pasquariello.pd

Are Financial Crises Indeed “Crises?” Evidence from the Emerging ADR Market

The recent episodes of financial turmoil in Mexico, East Asia, Russia, Brazil, and Argentina are often dubbed financial crises. However, the severe downturns in equity markets, abrupt currency devaluations, and massive capital flight that characterize these events can still be deemed compatible with efficient and well-functioning financial markets. Thus, why is a financial crisis a “crisis?” To answer this question, we conduct an empirical investigation of the efficiency and pricing of the emerging ADR market. More specifically, using a non-parametric technique, we test for regime shifts in two basic structural relationships for ADR returns in 20 emerging countries, identified via arbitrage and capital mobility considerations, that should always hold in efficient and integrated capital markets. We find that those “normal” market conditions were instead violated in proximity of financial crises: The law of one price often weakened (by 54% on average), and domestic sources of risk became more important (often by more than 100%) for many depositary receipts in our sample. We also find that some popular explanations for the occurrence of financial crises in emerging economies, in particular uncertainty among investors, exchange rate volatility, economic integration, and liquidity (but not contagion, financial integration, currency devaluations, capital flight, capital controls, or the legal environment for stock trading and holding) made their equity markets less efficient as well. Based on this evidence, we can state with greater confidence that those episodes of financial turmoil were indeed “crises.”http://deepblue.lib.umich.edu/bitstream/2027.42/21618/1/IPC-working-paper-009-Pasquariello.pd

Informative Trading or Just Noise? An Analysis of Currency Returns, Market Analysis of Currency Returns, Market Proximity of Central Bank Interventions

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 unless 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

Strategic Order Flow in the On-The-Run and Off-The-Run Bond Markets

We study the determinants of liquidity and price differentials between on-the-run and off-the-run U.S. Treasury bond markets. To guide our analysis, we develop a parsimonious model of multi-asset speculative trading in which endowment shocks separate the on-the-run security from an otherwise identical off-the-run security. We then explore the equilibrium implications of these shocks on both off/on-the-run price and liquidity differentials in the presence of two realistic market frictions - information heterogeneity and imperfect competition among informed traders - and a public signal. We test these implications by analyzing daily differences in market liquidity and yields for on-the-run and off-the-run three-month, six-month, and one-year U.S. Treasury bills and two-year, five-year, and ten-year U.S. Treasury notes. Our evidence suggests that i) off/on-the-run bid-ask spread differentials are economically and statistically significant, even after controlling for differences in several of the bonds' intrinsic characteristics (such as duration, convexity, or repo rates); ii) their corresponding yield differentials are neither, inconsistent with the illiquidity premium hypothesis; and iii) off/on-the-run liquidity differentials are larger for bonds of shorter maturity, immediately following bond auction dates, when the uncertainty surrounding the ensuing auction allocations is high, when the dispersion of beliefs across informed traders is high, and when macroeconomic announcements are noisy, consistent with our stylized model.http://deepblue.lib.umich.edu/bitstream/2027.42/48738/1/1054-Pasquariello.pd