Are Different-Currency Assets Imperfect Substitutes?

Martin Evans and Richard K. Lyons ()
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Martin Evans and Richard K. Lyons: Department of Economics, Georgetown University, http://www9.georgetown.edu/faculty/evansm1/

Working Papers from Georgetown University, Department of Economics

Abstract: This paper provides a new test for whether different-currency assets are imperfect substitutes. Past work on imperfect substitutability in foreign exchange falls into two groups: (1) tests using measures of asset supply and (2) tests using measures of central-bank asset demand. We address the demand side, but we use a broad measure of public demand, rather than focusing on demand by central banks. Under floating rates, changing public demand has no direct effect on interest rates, current or future. This provides an opportunity to test for effects from imperfect substitutability on price. We develop and estimate a micro portfolio balance model that has both Walrasian and microstructure features. Price effects from imperfect substitutability are clearly present: the immediate price impact of public trades is 0.44 percent per $1 billion (of which, about 80 percent persists indefinitely). This estimate is applicable to intervention trades as well, as long as they are sterilized, anonymous, and provide no monetary-policy signal.

Date: 2002-02-12
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