09/11 on the USD/EUR foreign exchange market

Abstract

We study the relationship between foreign exchange trading activity at a small bank in Germany and volatility on the USD/EUR foreign exchange market around the events of 09/11/2001. We find that volatility and bid-ask spreads are by far larger at that time, but the shock is not persistent. The positive correlation between volume and volatility does not break up, but intensifies strongly indicating the arrival of new information and increased price risk. We conclude that the USD/EUR foreign exchange market maintains its liquid structure and its efficient processing of exogenous shocks.

Acknowledgements

I would like to thank the editor Lucio Sarno and an anonymous referee. I would also like to thank Lukas Menkhoff, Michael Frömmel, Maik Schmeling, Daniela Beckmann and Josefin Cejie for their help. I am deeply indebted to the bankers who provided the data.

Notes

¹ Thus, we are only looking at the 09/11-effects on liquidity and not those on the payments and settlements systems as in Lacker (2004).

² Other works for example were based on models of ‘sequential information arrival’ (Copeland, 1976), according to which information reaches one market participant at a time. As that agent reacts to the arrival of news, his demand curve will shift, which leads to a positive correlation between volume and volatility (see for example, McMillan and Speight, 2002).

³ However, a limiting aspect of the MDH is that the relevance of factors working in different directions depends also on the horizon over which the analysis is conducted. At this point, we would like to thank the anonymous referee for his/her helpful remarks.

⁴ For an even more detailed description, please refer to Mende and Menkhoff (2005).

⁵ For a detailed description of this part of the dataset, please refer to Mende et al. (2004). Some cases are deleted from the data due to extreme price changes of more than 100 basis points or tiny volumes of less than 1000 USD, as both characteristics may blur the relationships of interest.

⁶ Each day we average out the overall bid and ask rate, i.e. amount of USD sold (bought) divided by amount of EUR bought (sold). We chose the midpoint as the daily exchange rate.

⁷ However, simple t-tests show that volatility and spreads after the event are not generally different from those before (not reported here).

⁸ A pip is the smallest unit in an exchange rate quote. For USD/EUR, it equals USD 0.0001.

⁹ The VAR analyses in EViews is carried out with lagged volatility and spread terms only. Thus, time 2 in Fig. 3 represents 09/11.

¹⁰ Bankers told us that they were actually still executing foreign exchange deals with their colleagues in the WTC, even after the first plane had crashed into one tower.