WO R K I N G PA P E R S E R I E S
N O 6 2 9 / M AY 2 0 0 6
A MARKET
MICROSTRUCTURE
ANALYSIS OF
FOREIGN EXCHANGE
INTERVENTION
ISSN 1561081-0


9 7 7 1 5 6 1 0 8 1 0 0 5
by Paolo Vitale

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W O R K I N G PA P E R S E R I E S
N O 6 2 9 / M AY 2 0 0 6
A MARKET
MICROSTRUCTURE
ANALYSIS OF
FOREIGN EXCHANGE
INTERVENTION 1
by Paolo Vitale 2
In 2006 all ECB
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1 Preliminary and incomplete. I would like to thank Francis Breedon and Ian Marsh for valuable comments and discussions. Hospitality
by ECB, where part of this research was undertaken, is kindly acknowledged. Any errors remain my responsibility.
2 Department of Economics and Land History, Gabriele D‘Annunzio University, Viale Pindaro 42, 65127 Pescara, Italy;
telephone: +39-085-453-7647; fax: +39-085-453-7639; e-mail: p.vitale@unich.it; webpage: http:/www/unich.it/~vitale.

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C O N T E N T S
Abstract
4
Non-technical summary
5
Introduction
7
1
The functioning of the spot FX markets
9
2
Basic set up
10
A. The FX market
11
B. The uncovered interest rate parity
15
C. The monetary market
16
D. The spot rate fundamental equation
17
3
The fundamental process
18
4
Order flow and central bank intervention
19
A. Direct intervention scenario
21
B. Indirect intervention scenario
23
5
Public information
24
6
Rational expectations equilibria
25
A. The equilibrium spot rate
25
B. The conditional variance of the spot rate
26
C. The fixed point problem
27
7
Discussion of the equilibria and
related literature
28
A. The characteristics of the equilibria
28
B review of related literature
30
8
Analysis of foreign exchange intervention
31
A. Benchmark parametrization
31
B. Efficiency and stability
33
C. Volatility, trading volume and liquidity
conditions
37
9
Concluding remarks
42
Appendices
43
References
52
European Central Bank Working Paper Series
55
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Working Paper Series No 629
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ABSTRACT
We formulate a market microstructure model of exchange determination we
employ to investigate the impact of foreign exchange intervention on exchange
rates and on foreign exchange (FX) market conditions. With our formulation
we show i) how foreign exchange intervention influences exchange rates via
both a portfolio-balance and a signalling channel and ii) derive a series of
testable implications which are coherent with a large body of empirical re-
search. Our investigation also proposes some normative recommendations,
as we show i) that in extreme circumstances large scale foreign exchange in-
tervention can have destabilizing effects for the functioning of FX markets
and ii) that the route chosen for the implementation of official intervention
has important implications for its impact on exchange rates and on market
conditions.
JEL Nos.: D82, G14 and G15.
Keywords: Official Intervention, Order Flow, Foreign Exchange Micro Struc-
ture, Exchange Rate Dynamics.
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NON TECHNICAL SUMMARY
The effect of central bank intervention in foreign exchange (FX) markets has always been
argument of significant disagreement among academics and practitioners. In effect, in the
early eighties general opinion among researchers and policymakers was that foreign exchange
intervention was ineffectual and that central banks should abstain from intervening. In line
with this view, most central banks followed an “hands-off” policy in FX markets. Such a
policy was interrupted in the mid-eighties by a series of individual and coordinated interven-
tion operations carried out by the monetary authorities of the G-5 countries. The relative
success of these operations suggested researchers, such as Dominguez and Frankel (1993a),
that foreign exchange intervention might be useful to condition market’s expectations and
exchange rates. Anyhow, despite the resumed activity of the monetary authorities of most
industrialized countries in the 1990s and the interest of researchers, the empirical research on
foreign exchange intervention has still not been able to determine when and how intervention
operations have a significant impact on the value of foreign currencies.
A contributory factor to the unresolved nature of this issue has been a lack of adequate
data on central bank intervention transactions. Indeed, until recently, researchers only had
access to data sets in which intervention operations were aggregated to daily or lower frequen-
cies. This has proved a serious impediment to empirical analysis of the effects of intervention
on exchange rates as, with coarsely sampled data, it is difficult/impossible to overcome si-
multaneity problems and to characterize the high-frequency effects of intervention on market
conditions. However, recently the increased competition between trading platforms and data
vendors has given researchers and practitioners access to detailed information on individual
transactions between FX traders.
Researchers have then been able to investigate the microstructure of FX markets and the
impact of trading activity on exchange rate dynamics, reaching the conclusion that net order
flow is an important determinant of exchange rate dynamics in the short term and possibly
even in the medium term.
Theoretical underpinnings of this empirical result link the explanatory power of order
flow to two different channels of transmission, due respectively to portfolio-balance and
information effects, whereas empirical studies
the impact of order flow on exchange rates
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suggest that in FX markets order flow possesses an information content. Indeed, the impact
of trade innovation on exchange rate is large, significant and persistent. There is also evidence
that order flow anticipates shifts in foreign exchange fundamentals.
We can associate this empirical evidence with foreign exchange intervention, as the mon-
etary authorities can employ this policy instrument to credibly signal their monetary policy.
This implies that order flow presents an informative component, sterilized central bank
operations, which anticipates shifts in short-term interest rates and monetary aggregates.
Consequently, it becomes important to understand how the intervention operations of a cen-
tral bank condition the functioning of FX markets, influencing their price formation process
and their market characteristics.
We analyze this issue from a market microstructure perspective, formulating a detailed
microstructure model of the spot FX markets which allows to study the effects of sterilized
intervention operations on market conditions and exchange rates via both the signalling and
portfolio-balance channels.
Thus, we show how sterilized intervention conditions currency values and exchange volatil-
ity. In addition, whereas foreign exchange intervention reduces market uncertainty on future
exchange rate fundamentals it also augments trading volume and transaction costs in FX
markets. Finally, our analysis offers some normative recommendations, as we show that
in extreme circumstances large scale foreign exchange intervention can have destabilizing
effects for the functioning of FX markets and that the choice of the route of intervention is
not without consequences.
In particular, intervention operations can be either negotiated with individual FX dealers
or channelled in the inter-dealer market on a centralized electronic limit order book. In the
former case foreign exchange intervention conveys more information. In addition, whereas
the former type of foreign exchange intervention reduces exchange rate volatility, the latter
presents the opposite effect. Finally, given that foreign exchange intervention is more infor-
mative when the central bank trades with individual FX dealers, in this case its impact on
the transaction costs of FX markets is larger.
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Introduction
Two important topics of research which have captured the attention of students of exchange
rate economics have been the investigation of the effects of foreign exchange intervention and
the analysis of the microstructure of foreign exchange (FX) markets.
In the 1980s a number of contributions have sighted to understand whether central bank
intervention operations in the markets for foreign exchange have important effects on currency
values, on exchange rate volatility and on market conditions. Indeed, theoretically it can be
established that sterilized intervention affects the value of currencies and the level of activity
in FX markets, either through a portfolio-balance channel or via a signalling channel.1 Thus,
several empirical investigations, e.g. Dominguez and Frankel (1993a,1993b), have analyzed the
actual effectiveness of sterilized intervention.2 These investigations have generally concluded
that foreign exchange intervention alters exchange rates, even if it is still unclear what monetary
authorities can actually achieve and how sterilized operations condition FX markets.
The inconclusive nature of this strand of research has been associated with the lack of
adequate high frequency data and of a microstructural perspective.3 Indeed, until the late
1990s no detailed data on FX transactions was available to researchers and it was not possible to
conduct any empirical study of microstructural aspects of FX markets with detailed information
on the trading activity of their participants. However, recently the increased competition
between trading platforms and data vendors has given researchers and practitioners access
to detailed information on individual transactions between FX traders. This has allowed
researchers to investigate the microstructure of FX markets and the impact of trading activity
on exchange rate dynamics.
The principal result of this new market microstructure approach to exchange rate determi-
nation is that order flow is an important determinant of exchange rate dynamics in the short
term and possibly even in the medium term.4 Theoretical underpinnings of this empirical
result link the explanatory power of order flow to two different channels of transmission, due
respectively to liquidity and information effects. With respect to the former channel, it has
simply been suggested that trade innovations perturb the inventories of FX investors which
need to be compensated with a shift in expected returns.
1See Mussa (1981), Bhattacharya and Weller (1997), Montgomery and Popper (2001) and Vitale (1999,2003).
2Edison (1993) and Sarno and Taylor (2000) contain extensive reviews of this literature.
3See Payne and Vitale (2003).
4See Lyons (2001) and Vitale (2004) for presentations of this literature.
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With respect to the latter, it has been claimed that the empirical failure of the asset market
approach lies with the particular forward looking nature of the exchange rate and with the
impact that news on exchange rate fundamentals, such as interest rates, employment levels
and so on, has on the value of currencies. When news arrivals condition market expectations
of future values of these fundamental variables, exchange rates immediately react anticipating
the effect of these fundamental shifts. Since news is hard to observe, it is difficult to control for
news effects in the empirical investigation of exchange rate dynamics and hence it is difficult
to conduct any meaningful analysis of the asset market approach.
However, the analysis of the relation between fundamental variables and exchange rates can
be bypassed by analyzing buying/selling pressure in FX markets, as the imbalance between
buyer-initiated and seller-initiated trades in FX markets, i.e. signed order flow, represents the
transmission link between information and exchange rates, in that it conveys information on
deeper determinants of exchange rates, which FX markets need to aggregate and impound
in currency values. More specifically, as it is typical of rational expectations (RE) models of
asset pricing, FX traders collect from various sources information on the fundamental value
of foreign currencies and trade accordingly. A general consensus and equilibrium exchange
rates are then reached via the trading process, in that information contained in order flow is
progressively shared among market participants and incorporated into exchange rates.
Empirical studies of the impact of order flow on exchange rates, notably Lyons (1995),
Payne (2003), Biønnes and Rime (2005), and Evans and Lyons (2005), suggest that in FX
markets order flow possesses an information content. Indeed, the impact of trade innovation
on exchange rate is large, significant and persistent. There is also evidence that order flow
anticipates shifts in foreign exchange fundamentals.
Following Mussa (1981), we can associate this empirical evidence with foreign exchange
intervention, as the monetary authorities can employ this policy instrument to credibly sig-
nal their monetary policy. This implies that order flow presents an informative component,
sterilized central bank operations, which anticipates shifts in short-term interest rates and
monetary aggregates. Consequently, it becomes important to understand how the intervention
operations of a central bank condition the functioning of FX markets, influencing their price
formation process and their market characteristics.
We analyze this issue from a market microstructure perspective, formulating a detailed
microstructure model of the spot FX markets. This framework allows to study the effects
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of sterilized intervention operations on market conditions and exchange rates via both the
signalling and portfolio-balance channels.
Our framework presents two important features: i) it allows the identification of a clear
link between the intervention operations of a central bank, traders’ expectations and exchange
rates; ii) it produces a series of testable implications which are consistent with a large body
of empirical evidence concerning the statistical relations between intervention operations, ex-
change rates and monetary aggregates. This framework also sheds light on the impact of
central bank activity on the liquidity and efficiency of FX markets. In addition, it permits
studying the different effects of alternative intervention strategies, as central banks may decide
to feed their intervention operations through different trading routes.
This paper is organized as follows. In Section I we briefly present the main features of the
structure of the markets for foreign exchange. In Sections II to VI we develop our analytical
framework. Thus, in Section II we describe how foreign exchange contracts are traded in FX
markets and set out the corresponding equilibrium conditions; in Section III we discuss the
dynamics of the fundamental process which governs the spot rate; in Section IV we introduce
foreign exchange intervention; in the following Section we discuss the role of public information;
and finally in Section VI we characterize the RE equilibria of the model.
In Section VII we analyze the characteristics of these equilibria in light of the recent market
microstructure approach to exchange rate determination. In the following Section we employ
our model to investigate the impact of foreign exchange intervention on currency values and
on market conditions. We also debate the relevance of alternative routes of intervention. In
the last Section we offer some final remarks.
I. The Functioning of the Spot FX Markets
Before we can introduce a model of exchange rate determination which attempts to replicate
the structure of the spot FX markets we first need to describe how these markets operate.
Spot FX markets are dealership markets, where dealers trade spot contracts for foreign
currencies among themselves and with their customers. Clients usually contact FX dealers
which operate as market makers, ie. are ready to trade foreign currencies with their customers.
When called they quote bid and ask prices at which they are respectively willing to buy and
sell a specific foreign currency. Customers can complete transactions at the quoted prices and
can search the best quotes contacting several FX dealers before completing an order. When
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Document Outline

• A market microstructure analysis of foreign exchange intervention
• Contents
• Abstract
• Non-technical summary
• Introduction
• I. The Functioning of the Spot FX Markets
• II. Basic Set Up
  • A. The FX Market
  • B. The Uncovered Interest Rate Parity
  • C. The Monetary Market
  • D. The Spot Rate Fundamental Equation
• III. The Fundamental Process
• IV. Order Flow and Central Bank Intervention
  • A. Direct Intervention Scenario
  • B. Indirect Intervention Scenario
• V. Public Information
• VI. Rational Expectations Equilibria
  • A. The Equilibrium Spot Rate
  • B. The Conditional Variance of the Spot Rate
  • C. The Fixed Point Problem
• VII. Discussion of the Equilibria and Related Literature
  • A. The Characteristics of the Equilibria
  • B. Review of Related Literature
• VIII. Analysis of Foreign Exchange Intervention
  • A. Benchmark Parametrization
  • B. Efficiency and Stability
  • C. Volatility, Trading Volume and Liquidity Conditions
• IX. Concluding Remarks
• Appendix I
  • A. FX Dealers' Information
  • B. FX Dealers' Expectations
  • C. FX Dealers' Average Expectations
  • D. The Equilibrium Spot Rate
  • E. Conjectured and Actual Equilibria
• Appendix II
  • A. FX Dealers's Information
  • B. FX Dealers' Expectations
  • C. The Equilibrium Spot Rate
• References
• European Central Bank Working Paper Series

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