Government Intervention and Adverse Selection Costs in Foreign Exchange Markets

Posted: 8 Dec 1999

See all articles by Mahendrarajah Nimalendran

Mahendrarajah Nimalendran

University of Florida - Department of Finance, Insurance and Real Estate

Andy Naranjo

University of Florida - Warrington College of Business Administration

Abstract

An important group of traders in the foreign exchange market are governments who often adhere to a foreign exchange rate policy of occasional interventions with otherwise floating rates. In this paper, 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. and German DM/$ 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.

JEL Classification: F31, G14, G15, G18

Suggested Citation

Nimalendran, Mahendrarajah and Naranjo, Andy, Government Intervention and Adverse Selection Costs in Foreign Exchange Markets. Review of Financial Studies, Vol. 13, Iss. 2, Available at SSRN: https://ssrn.com/abstract=197656

Mahendrarajah Nimalendran (Contact Author)

University of Florida - Department of Finance, Insurance and Real Estate ( email )

P.O. Box 117168
Gainesville, FL 32611
United States
352-392-9526 (Phone)
352-392-0301 (Fax)

Andy Naranjo

University of Florida - Warrington College of Business Administration ( email )

P.O. Box 117168
Gainesville, FL 32611-7168
United States
352-392-3781 (Phone)

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