Government intervention and adverse selection costs in foreign exchange markets

Authors: Nimalendran M.; Naranjo A.

Source: Review of Financial Studies, Volume 13, Number 2, 2000 , pp. 453-477(25)

Publisher: Oxford University Press

Abstract:

An important group of traders in the foreign exchange market is governments who often adhere to a foreign exchange rate policy of occasional interventions with otherwise floating rates. In this article we provide a theoretical model and empirical evidence that government foreign exchange interventions create significant adverse selection problems for dealers. In particular, our model shows that the adverse selection component of the foreign exchange spread is positively related to the variance of unexpected intervention and that expected intervention has no impact on the spread. After controlling for inventory and order processing costs, we find that bid-ask spreads increase with U.S. dollar and German deutsche mark foreign exchange rate intervention during the period 1976-1994. Furthermore, when the intervention is decomposed into expected and unexpected components, we find a statistically and economically significant increase in spreads with the variance of unexpected intervention, while expected intervention has no significant impact on spreads.

Document Type: Original article

Affiliations: University of Florida, Warrington College of Business, Department of Finance, PO Box 117168, Gainesville, FL 32611-7168, USA : 1: Corresponding author

Publication date: 2000-01-01

• The Review of Financial Studies is a major forum for the promotion and wide dissemination of significant new research in financial economics. As reflected by its broadly based editorial board, the Review balances theoretical and empirical contributions. The primary criteria for publishing a paper are its quality and importance to the field of finance, without undue regard to its technical difficulty. Finance is interpreted broadly to include the interface between finance and economics. The Review is sponsored by The Society for Financial Studies. The editors of the Review and officers of the Society are elected for limited terms.

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• By this author: Nimalendran M. ;  Naranjo A.

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