DON'T REGULATE THE CURRENCY MARKETS: THEIR VOLATILITY REFLECTS THE PACE OF ARRIVAL OF NEW INFORMATION

Should the foreign exchange (FX) markets be regulated because of 'excessive volatility' and massive trading volume unrelated to the underlying trade in goods and other financial assets? Is FX trading 'self-generating' so that government-imposed restrictions or taxes would help ensure that exchange rates are more closely related to the 'fundamentals' that are supposed to determine exchange rates?

New research by Michael Melvin and Xixi Yin, published in the latest issue of the Economic Journal, provides evidence on this important public policy issue by examining the link between the arrival of new public information, the frequency of quoting FX prices and the volatility of exchange rates. It indicates that both the number of price revisions (quotes) and the volatility of exchange rate returns for the yen and mark are functions of the rate of public information or news hitting the market. In other words, FX trading is providing the function it is meant to: adjusting prices and quantities in response to new information in order to achieve an efficient allocation of resources.

The researchers have collected tick-by-tick data on the Japanese yen and German mark as displayed on the Reuters indicative quoting screen over the period from 1 December 1993 to 26 April 1995. They measure public information by the number of news headlines related to the United States, Germany or Japan reported on the Reuters Money Market Headline News screen for the same period. Data are aggregated to the hourly level for all series.

Due to strong 'time-of-day effects' in both the pace of news arrival and foreign exchange activity, it is important to remove any regular pattern of 'intraday seasonality' in the data. In this sense, the study asks the following question: when there is more than the normal amount of information arriving for a particular hour of a particular day of the week, is there more than the normal amount of quoting activity and exchange rate volatility? The researchers answer this question with a positive 'yes'.

These results have important implications for the debate over regulation of the market and proposals to 'throw sand in the wheels of international finance'. Supporters of such regulation seek to permit 'normal functioning' of the FX market but want to limit opportunities for 'noise trading' and 'self-fulfilling speculative movements'. Proposals for transaction taxes or non-interest-bearing deposit requirements to trade currencies are supposed to reduce the activity of those who trade on anything other than information regarding 'fundamentals'.

The results of this analysis do not support the hypothesis that FX trading activity is largely self-generating and unrelated to new information. This suggests that trading is providing the function it is meant to: adjusting prices and quantities to achieve an efficient allocation of resources. Melvin and Yin conclude that until there is robust evidence to support claims of 'self-generating trading' or 'excess volatility' unrelated to fundamentals that can be reduced by raising the costs of trading, proposals for imposing such costs must be treated with considerable caution.

Note for Editors: 'Public Information Arrival, Exchange Rate Volatility and Quote Frequency' by Michael Melvin and Xixi Yin is published in the July 2000 issue of the Economic Journal. Melvin is at Arizona State University; Yin is at the American Express Company.

For Further Information: contact Michael Melvin via email: michael.melvin@asu.edu; RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email: romesh@compuserve.com); or RES Media Assistant Niall Flynn on 020-7878-2919 (email: nflynn@cepr.org).