Journal of Banking and Finance 127 (2021) 106124

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Journal of Banking and Finance

journal homepage: www.elsevier.com/locate/jbf

The impact of RMB’s SDR inclusion on price discovery in

onshore-offshore marketsR
Yu-Lun Chen a, Ke Xu b,1,∗
a
Department of Finance, College of Business, Chung Yuan Christian University, 200 Chung Pei Rd., Jhongli, Taoyuan 32023, Taiwan
b
Department of Economics, University of Victoria, Canada

a r t i c l e i n f o a b s t r a c t

Article history: In this study, we leverage various price discovery measurements to investigate whether and how the ad-
Received 15 April 2020 dition of the Chinese yuan in Special Drawing Right (SDR) affected price discovery in onshore (USD/CNY)
Accepted 19 March 2021
and offshore (USD/CNH) markets. The results show that the less regulated offshore exchange rates con-
Available online 24 March 2021
tribute more to price discovery than the onshore rates do. Including the yuan in SDR does not change
JEL classification: the relative price discovery contributions of the onshore and offshore markets, and more importantly, it
G14 enhances the overall price efficiency in both markets, due to lower autocorrelations in the error correc-
G15 tion term and fewer arbitrage opportunities. In particular, the price spreads between the onshore and
offshore markets decrease, implying that arbitrage opportunities have diminished, as market integration
Keywords:
has increased, following the inclusion of the yuan in SDR.
Special drawing right
RMB internationalization © 2021 Elsevier B.V. All rights reserved.
Fractional cointegration
Price discovery
Pricing error
Variance ratio

1. Introduction
The U.S. dollar still has the largest share of global holdings, but
central banks have been trying to increase and diversify their re-
serve assets in recent years. According to the Currency Compo-
sition of Official Foreign Exchange Reserves (COFER) database of
the International Monetary Fund (IMF), allocated reserves claimed
in the U.S. dollar stood at US$6.79 trillion, accounting for 61.99%
of allocated reserves in the first quarter of 2020, compared with
5.50 trillion, or 65.36%, in the fourth quarter of 2016. The RMB’s
share of allocated reserves hits a record level, rising to 2.02% in
the first quarter of 2020, compared with 1.07% in the fourth quar-
ter of 2016.2 The 2019 report by the Society for Worldwide Inter-
bank Financial Telecommunication (SWIFT) showed that the 2016
addition of the RMB to IMF’s Special Drawing Right (SDR) bas-
R
We gratefully acknowledge financial support from the Ministry of Science and
Technology, Taiwan (MOST 109-2410-H-033 -002 -MY2) and the Social Sciences and
Humanities Research Council (SSHRC) Insight Development Grants, Canada (430-
2018-00557).
∗
Corresponding author.
E-mail addresses: yoloom@cycu.edu.tw (Y.-L. Chen), kexu@uvic.ca (K. Xu).
1
Ke Xu is grateful to the Social Sciences and Humanities Research Council
(SSHRC) Insight Development Grants (430-2018-00557) for Financial support. We
thank Morten Nielsen and Michael King for helpful comments on an earlier draft.
2
The renminbi (abbreviated RMB) is the official currency of China.
ket was a big step; since then, many central banks have added
the RMB to their mix of reserve currencies. The use of RMB has
increased significantly, in both cross-border transactions within
Mainland China and in offshore markets. In parallel, the increased
use of the RMB in trade has helped to make it even more popu-
lar, especially among businesses involved in importing or exporting
Chinese goods that seek advantages such as limiting exchange rate
risks.
The SDR, a synthetic currency created in 1969 by the IMF, func-
tions not only as a composite alternative reserve asset but also as a
reference for transactions undertaken by official institutions and as
a unit of accounting. By adding the RMB to SDR on 1 October 2016,
the IMF signaled its significant role in the global economy and
denoted it as a “freely usable” currency, frequently employed for
international transactions and widely traded in exchange markets.
The RMB being established as an international currency in turn can
facilitate trade-related invoicing and global liquidity (Ito, 2017). In
this study, we leverage various price discovery measurements to
investigate whether and how the addition of RMB in SDR has af-
fected the relative and absolute price discovery of RMB onshore
and offshore markets.
Price discovery is the process by which the market in-
corporates all price-relevant information into prices. Frijns and
Zwinkels (2018) point out that price discovery is an important is-
sue in market microstructure literature, particularly when an iden-

https://doi.org/10.1016/j.jbankfin.2021.106124
0378-4266/© 2021 Elsevier B.V. All rights reserved.
Y.-L. Chen and K. Xu
tical asset is traded on multiple markets. By identifying which mar-
kets contributes more to price discovery, we can understand which
market is more efficient in reflecting information to its prices. Ex-
change transactions between the U.S. dollar and RMB (the curren-
cies of the world’s top 2 economies) coexist in onshore (USD/CNY)
and offshore (USD/CNH) markets. Understanding which market can
reflect new information faster and whether adding RMB in SDR af-
fects this price efficiency matters for academic researchers, policy
makers, and investors.
In an ideal world with perfect information, onshore USD/CNY
and offshore USD/CNH exchange rates would be determined by
expectations regarding macroeconomic fundamentals like inflation,
productivity growth, and interest rates (Rime, 2003) and the two
exchange rates would incorporate public information quickly and
simultaneously, such that there would be no lead-lag relation-
ship to reflect public information between USD/CNY and USD/CNH
rates. However, the real world allows for imperfect information,
heterogeneous preferences, and regulatory restrictions. Different
market frictions in onshore and offshore markets may allow the
relative lead-lag relationship in USD/CNY and USD/CNH rates to
persist, reflecting the available information.
The offshore USD/CNH market is a free market, accessible by
all entities for any purpose (e.g., trade settlements, investments,
hedging). Its exchange rate is determined by offshore market par-
ticipants and market forces. There are no daily trading band re-
strictions, and it is free from intervention by the People’s Bank of
China. In contrast, the onshore USD/CNY market remains highly
regulated. The Chinese government maintains capital control reg-
ulations that restrict cross-border capital flows, and segregation
thus arises. Access to the wholesale onshore market is granted only
to domestic banks, finance companies (subsidiaries of large state-
owned enterprises), and domestic subsidiaries of foreign banks.
Since the implementation of the managed floating policy, USD/CNY
rate movements have continued to be subject to a daily trading
band of 2%. Accordingly, different market regulations and investor
structures may induce the difference of USD/CNY and USD/CNH
market prices to reflect identical macroeconomic information. Ar-
guably, the offshore market may enjoy the advantages of less reg-
ulation and restriction, broader investor participation, and fewer
government interventions in reflecting information.
Only a few previous studies analyze the contribu-
tions of USD/CNY and USD/CNH rates to price discovery.
Ding et al. (2014) note that USD/CNY rate returns provide lit-
tle explanatory power for USD/CNH rate returns (and vice versa),
which highlights the lack of information integration across onshore
and offshore spot markets. Xu et al. (2017) find that price discov-
ery in the relationship between USD/CNY and USD/CNH rates is
uncertain between April 2012 and October 2015. Chen, 2020 ar-
gues though that USD/CNH rates provide greater contributions to
price discovery than USD/CNY rates, attributed to an improved
central parity quotation policy that came into effect on August 11,
2015.
More importantly, adding RMB in SDR may increase the at-
tention and confidence of the public and private sectors to RMB
investment opportunities, and global investors have incentives to
rebalance their portfolio holdings and upgrade their asset alloca-
tions to include RMB. The commonly increased use (or liquidity)
of the RMB in onshore and offshore markets may benefit price
discovery and price integration. Ranaldo and Santucci de Mag-
istris (2019) point out that liquidity begets price efficiency by sys-
tematically reducing pricing errors and facilitating information in-
tegration processing. More liquid currencies are less prone to ar-
bitrage deviations. Boehmer and Kelley (2009) affirm that prices
should move closer to their fundamental values when markets be-
come more liquid. In addition, Schrimpf and Sushko show that
the price spreads between USD/CNY and USD/CNH were lower in
2
Journal of Banking and Finance 127 (2021) 106124
2019 than in 2016, suggesting smaller arbitrage deviations between
onshore-offshore rates in recent years. Accordingly, we hypothesize
that the increased use of RMB after the inclusion of RMB in SDR
should benefit price discovery and price integration in onshore and
offshore markets.
In this study, we investigate the contributions of onshore and
offshore markets to price discovery over the period from July 1,
2014, to December 31, 2018, using USD/CNY and USD/CNH intra-
day price data. We consider several approaches to analyze the
price discovery in RMB onshore and offshore markets over two
sub-sample periods, separated by the SDR implementation day
(October 1, 2016). We begin our price discovery analysis by us-
ing the pricing error measurement of Hasbrouck (1993), for on-
shore USD/CNY and offshore USD/CNH prices separately. Following
Hasbrouck (1993) and Boehmer and Kelley (2009), we use a vec-
tor autoregression (VAR) model to separate the variation of an on-
shore (and offshore) market’s efficient price from the variation of a
pricing error. The variance of the pricing error serves as our main
measure of informational efficiency. We also compute the vari-
ance ratio to examine informational efficiency for the USD/CNY and
USD/CNH markets separately, in line with Kaul and Sapp (2009),
Boehmer and Kelley (2009), and Boehmer and Wu (2013).
The results of the pricing error and variance ratio analyses show
that the less regulated offshore USD/CNH rates contribute more to
price discovery than the onshore USD/CNY rates. Including RMB in
the SDR improves the price efficiency of the two markets simulta-
neously, but it would not change the dominance of USD/CNH rates
in price discovery. These findings imply that, after the RMB joined
the SDR, more traders may have incentives to include the RMB
onshore and offshore assets in their portfolios and to exchange
USD/CNH and USD/CNY rates, benefiting price discovery in both
markets simultaneously.
To check whether the improvement of price efficiency in both
onshore USD/CNY and offshore USD/CNH markets can be attributed
solely to the inclusion of RMB in SDR, we examine the pricing er-
ror and variance ratio measurements on a daily basis for both RMB
markets surrounding the SDR announcement day (November 30,
2015) and implementation day.3 We examine and test the daily
pricing error and variance ratio measurements from 20 days be-
fore the SDR implementation (and announcement) to 20 days after.
The results of [-20, +20] daily price efficiency measurements sur-
rounding the SDR implementation day reveal significantly smaller
pricing errors and variance ratio measurements in both onshore
and offshore markets after the SDR implementation day, compared
with before. In contrast, there is an insignificant reduction in the
pricing errors of the onshore USD/CNY and the offshore USD/CNH
across the SDR announcement day. After the announcement that
RMB would be added to the SDR basket, traders did not adjust
their asset allocations or enhance the liquidity of USD/CNH and
USD/CNY markets immediately.
To distinguish the effect of adding the RMB in SDR from overall
time trends, we also conduct placebo tests, in which we randomly
choose some time points and compare the price efficiency mea-
sures before and after them. The pseudo-announcement (pseudo-
implementation) day is two months before the SDR announce-
ment (implementation) day, on 2015-09-30 (2016-08-01). We do
not observe any significant changes in the price efficiency mea-
3
We thank an anonymous referee for suggesting the consideration of daily pric-
ing errors and variance ratio measurements surrounding SDR implementation and
announcement days to avoid other disturbances in price efficiency. Although pre-
vious studies on the addition of a currency to the SDR are rare, the addition of a
stock to the indices, such as Morgan Stanley Capital International or S&P 500, has
been widely documented (Chakrabarti et al., 2005; Hau et al., 2010; Afego, 2017).
These studies identify significant changes as of the announcement day. Similarly,
we consider both the impact of the announcement and the effective SDR inclusion
effect.
Y.-L. Chen and K. Xu Journal of Banking and Finance 127 (2021) 106124

sures before and after the pseudo-announcement and pseudo- Table 1

Descriptive statistics.
implementation days, confirming that our findings on the price
discovery improvement of RMB onshore and offshore markets can Price levels Differences
be attributed solely to the SDR inclusion. PtCNY PtCNH Spreadt PtCNY PtCNH
Finally, to explore the price interactions of USD/CNY and
Panel A: Before SDR
USD/CNH markets in the system and understand the relative and Mean 6.3887 6.4031 −0.0144 0.0043 0.0044
absolute price discovery, we adopt the fractionally cointegrated Std Dev 0.1860 0.1911 0.0221 2.8023 1.3533
vector autoregressive (FCVAR) model.4 This analysis is different Max 6.7010 6.7443 0.0438 179.0692 236.5678
from previous price discovery literature that exclusively investi- Min 6.1095 6.1119 −0.1606 −90.8371 −66.8502
Skewness 0.1093 0.0281 −2.3609 2.2848 41.4567
gates “who moves first” in the process of price adjustment and we
Kurtosis 1.5758 1.5183 9.5653 223.9864 739.8100
also emphasize the examination of total information that are im- ADF Test 0.9759 0.9441 0.001 0.001 0.001
pounded in all market prices, or the speed of adjustment for all
Panel B: After SDR
related markets.5 We know of no other studies that examine price
Mean 6.7059 6.7048 0.0011 0.0014 0.0013
discovery in foreign exchange markets empirically with an FCVAR Std Dev 0.2110 0.2109 0.0138 2.3281 1.3685
model, in an explicit effort to consider the degree of long mem- Max 6.9741 6.9870 0.1054 75.7394 70.3534
ory effects on high frequency intra-day data. A FCVAR model en- Min 6.2414 6.2377 −0.0506 −98.0278 −99.3600
compasses the features of a non-fractional CVAR model but also Skewness −0.7005 −0.7210 1.5845 −0.2771 −1.6873
Kurtosis 2.1381 2.1884 9.3315 107.6189 581.8808
includes long memory features in the error correction term, so it ADF Test 0.9717 0.9639 0.001 0.001 0.001
can support estimations of the degree of fractional cointegration.
Notes: This table reports the summary statistics on the levels and returns of
A higher estimate of the fractional parameter implies less memory
the one-minute USD/CNY (PtCNY ) and USD/CNH (PtCNH ) rates and their spreads
in the error correction term and thus enhanced market efficiency. (Spreadt ) for two subsamples, before SDR (July 1, 2014, to September 30, 2016)
With our novel approach, we affirm that USD/CNH rates con- and after SDR (October 1, 2016, to December 31, 2018). The spreads between
tribute more to price discovery than USD/CNY rates. Including RMB the USD/CNY and USD/CNH rates are calculated by Spreadt = PtCNY − PtCNH . The
in the SDR does not change the relative price discovery contribu- differences in the USD/CNY and USD/CNH rates are calculated by taking the
first difference in the log prices, multiplied by 10,0 0 0. The augmented Dickey-
tion of the onshore and offshore markets. After the SDR implemen-
Fuller (ADF) test applies to the null hypothesis that the series have a unit root,
tation, onshore and offshore markets became better integrated, due with an optimal of 14 lags. The p-values for the ADF test are reported.
to less memory in the error correction term (equilibrium pricing
errors), implying improved price efficiency in both RMB markets.
The diminished price differences between the offshore and onshore RMB in the SDR basket was announced on November 30, 2015, and
markets also indicate reduced arbitrage opportunities after the in- implemented on October 1, 2016.
clusion of RMB in SDR. The addition of RMB in the SDR basket thus Fig. 1 plots the two data series and their spreads. The USD/CNY
appears to have enhanced price efficiency and integration in both rates were clearly lower than the USD/CNH rates prior to the in-
onshore and offshore markets. clusion of the RMB in the SDR basket (vertical dashed line). Dur-
In the next section, we describe the data. Section 3 contains the ing the RMB depreciation period before October 1, 2016, the off-
empirical analysis. In Section 4, we discuss the implications of our shore free market experienced a relatively greater depreciation,
results, and Section 5 concludes. which enlarged the spreads between the two markets. After that
day, more fluctuations in the two rates occurred, and the spread
2. Data description between onshore and offshore markets varied from positive to
negative. It thus appears that onshore and offshore markets be-
We use one-minute intraday data on USD/CNY and USD/CNH came better integrated and induced unpredictable spreads, such
rates to analyze the price efficiency in the sample period (July 2014 that it may be more difficult for investors to take advantage of the
to Dec 2018). The trading hours in the two markets run from 9:30 spreads to arbitrage after SDR implementation.
to 16:30, and we exclude open and close prices from this study. The descriptive statistics for the two subsample periods before
In total, we have two high-frequency intraday time series contain- and after SDR are shown in Table 1. Although the average USD/CNY
ing 780,378 observations. Our data sample comes from the Wind and USD/CNH rates are very similar, the USD/CNY rates are below
Database (provided by the Wind Information Company, a major USD/CNH rates during the period before SDR, whereas this rela-
financial data vendor in China). Many previous studies focusing tionship reverses after the SDR implementation. Furthermore, the
on equity or foreign exchange markets in China have adopted the standard deviation in the USD/CNH rates is slightly higher than
Wind Database too.6 The bid and ask quotes data for the USD/CNY that for the USD/CNY rates before SDR. But the standard devia-
and USD/CNH are collected from Tick Data, LLC. The inclusion of tion in both markets is almost the same after SDR. The average
spreads in the USD/CNY and USD/CNH rates are also larger in ab-
solute value before compared with after SDR, which indicates that
4
In equilibrium relationships across foreign exchange markets, fractional integra-
the two markets are better integrated after the inclusion of RMB
tion (or long memory) instead may emerge (Baillie and Bollerslev, 1994; Gil-Alana
and Carcel, 2018), which would imply fractional cointegration among the exchange in SDR. The last two columns in Table 1 show the one-minute re-
rates. Furthermore, long memory characteristics may mean that an error correc- turns in the USD/CNY and USD/CNH rates. The average returns in
tion term responds slowly to shocks, so deviations from equilibrium persist, and both the onshore and offshore markets are higher before SDR than
the equilibrium error is more substantial. Even if the exchange rates are I (1 ), β Xt after SDR. The standard deviations of USD/CNY rates returns are
is fractionally integrated at a lower order between 0 and 1. According to Baillie and
Bollerslev (1994), the error correction term of six exchange rates, β Xt , exhibits long
larger than those of USD/CNH rates returns before and after SDR.7
memory characteristics. They also argue that the autocorrelation coefficients of the
error correction term decay slowly.
5
Previous studies, such as those by Hasbrouck (1995), Hasbrouck (2003), Eun and stitutions, and regulatory bodies. Overseas, it serves 75% of all qualified foreign in-
Sabherwal (2003), Chakravarty et al. (2004), and Brogaard et al. (2019) indicate stitutional investors.
where price discovery takes place when markets are fragmented. 7
We thank an anonymous reviewer for noting the higher volatility of regulated
6
The Wind Information Company provides real-time fundamental data, exchange USD/CNY rates in our sample data. The higher standard deviation of offshore mar-
rate data, and estimated earnings data for financial professionals. In China, the com- ket before and after the SDR event may result from the time series dependence
pany serves more than 90% of financial institutions, including hedge funds, asset in the market microstructure noise of high frequency data. Market microstructure
management firms, securities companies, insurance companies, banks, research in- noise in high frequency financial data can exhibit serial correlation, as suggested by

3
Y.-L. Chen and K. Xu
Fig. 1. One-minute USD/CNY and USD/CNH rates. Notes: One-minute rates of USD/CNY and USD/CNH, and the spread between the two rates (USD/CNY minus USD/CNH), July
2014–December 2018. The vertical dashed lines indicate the announcement (November 30, 2015) and the implementation (October 1, 2016) of the RMB in the SDR basket.
We conduct augmented Dickey-Fuller (ADF) tests to examine
whether our time series contain a unit root. Table 1 reports the
results of the ADF tests for the levels, spreads, and differences in
the USD/CNY and USD/CNH rates. The ADF test suggests that the
levels of the two rates have a unit root in both periods, before and
after SDR. This finding further confirms our prediction that the or-
der of integration for PtCNY and PtCNH are both I (1 ) (d = 1). The ADF
tests reject the existence of a unit root in the spreads and the dif-
ferences of the two rates.
3. Empirical analysis
This section examines the impact of adding the RMB to the
SDR on liquidity and price discovery in USD/CNY and USD/CNH
markets. To measure liquidity in the individual market, we exam-
ine bid-ask spread and percentage bid-ask spread in USD/CNY and
USD/CNH markets, respectively, according to Funke et al. (2015).8
We adopt pricing error and variance ratio measurements to mea-
sure price discovery in each individual market. Then, we apply the
FCVAR model to estimate price discovery jointly in the USD/CNY
and USD/CNH markets. We find that the USD/CNH market is dom-
inant in the price discovery process and, after the SDR implemen-
tation day, both markets’ price efficiency levels improve.
Hansen and Lunde (2006) and Aït-Sahalia et al. (2011). The first-order and second-
order autocorrelation coefficients of offshore (USD/CNY) are −0.340 and −0.035 in
the full sample period. Those of onshore (USD/CNH) are 0.023 and 0.001. These
values indicate that higher serial correlation or microstructure noise may result
in higher standard deviations in offshore USD/CNY rate returns. We also check
the price discovery between USD/CNY and USD/CNH markets for one-minute, five-
minute, ten-minute, thirty-minute, and one-hour data and find consistent results
for these different frequencies. These results are available on request.
8
We thank an anonymous referee for suggesting the consideration of liquidity’s
role in the complete analysis of the RMB’s SDR inclusion on price discovery. The
percentage bid-ask spread is calculated by dividing the bid-ask spread (i.e., ask
quote minus bid quote) by the average of the bid and ask quotes. Bid-ask spread
is a well-known measure on liquidity-the more liquid an asset, the tighter spread.
Funke et al. (2015) use the bid-ask spread and percentage bid-ask spread to mea-
sure the liquidity condition of USD/CNY and USD/CNH markets.
4
Journal of Banking and Finance 127 (2021) 106124
3.1. Individual analysis of price discovery in onshore and offshore
RMB markets
We begin our empirical analysis by studying the impact of the
inclusion of RMB in the SDR basket on liquidity and price discovery
in onshore and offshore RMB markets. We consider the common
liquidity measurements including bid-ask spread and percentage
bid-ask spread and examine pricing error (Hasbrouck, 1993) and
variance ratio measurements (Boehmer and Kelley, 2009) for infor-
mational efficiency in the USD/CNY and USD/CNH markets.
Hasbrouck (1993) suggests decomposing the market price ( pt )
into a random-walk component and a transitory stationary compo-
nent (i.e., pt = mt + st ). The random-walk component (mt ) reflects
the efficient price. The efficient price change permanently im-
pounded into the price is presumably due to new information and
fundamental change. The market price may differ from the efficient
price transiently (e.g., uninformative bid-ask bounce, inventory
control, discreteness). The transitory component (st ) is the pricing
error. Hasbrouck proposes that pricing error (i.e., the deviation of
observed transaction prices from unobserved efficient prices) offers
an alternative measure of the implicit transaction costs incurred by
traders. The variance of the pricing error determines how closely
actual transaction prices track the efficient price.
To measure the variance of the pricing error (Hasbrouck, 1993),
we estimate the following vector autoregression (VAR) of USD/CNH
(and USD/CNY) price changes and trades. Using impulse responses
of the VAR, we can separate actual price changes into permanent
informational shock and transient shock from trade:9
rt = a1 rt−1 + a2 rt−2 + . . . + b1 xt−1 + b2 xt−2 + . . . v1,t ,
xt = c1 rt−1 + c2 rt−2 + . . . + d1 xt−1 + d2 xt−2 + . . . v2,t , (1)
where rt and xt are the log price changes and trade sign indica-
tor in each market (according to the tick rule, we classify a buy
9
Impulse responses trace the responsiveness of the dependent variables in the
VAR to shocks to each of the variables.
Y.-L. Chen and K. Xu
order as 1 and a sell order as 1).10 Furthermore, v1,t and v2,t are
the zero mean and serially uncorrelated disturbances. The VAR in
Eq. (1) can be transformed to the vector moving average (VMA)
that expresses the variables in terms of current and lagged distur-
bances, as follows:
rt = a∗0 v1,t + a∗1 v1,t−1 + a∗2 v1,t−2 + . . . + b∗0 v2,t + b∗1 v2,t−1 + b∗2 v2,t−2 + . . . ,
xt = c0∗ v1,t + c1∗ v1,t−1 + c2∗ v1,t−2 + . . . + d0∗ v2,t + d1∗ v2,t−1 + d2∗ v2,t−2 + . . . ,
where the VMA coefficients . . .), (a∗0
. . .), (b∗0
. . .), and (c0∗
. . .) can (d0∗
be calculated by forecasting the VAR system in Eq. (1), obtained
using impulse responses. To calculate pricing error (st ), only the
rt equation in Eq. (2) is needed, because Hasbrouck (1993) shows
that an expanded representation for pricing errors is
st = (α0 v1,t + α1 v1,t−1 + . . . ) + (β0 v2,t + β1 v2,t−1 + . . . )
+ (ηt + γ1 ηt−1 + . . . ),
where (α0 v1,t + α1 v1,t−1 + . . . ) captures pricing errors due to the
current and lagged price adjustment regarding adverse-selection
(information-correlated) effects, and (β0 v2,t + β1 v2,t−1 + . . . ) cap-
tures pricing errors due to the current and lagged trades adjust-
ment, such as inventory control mechanisms. In addition, η1 is a
zero-mean, covariance-stationary process, orthogonal to all com-
ponents of v1,t and v2,t . By a generalization of Beveridge and Nel-
son (1981)’s demonstration, α j and β j in Eq. (3) may be computed
with the BN identification restriction (ηt = γ1 = . . . = 0 ) and the
VMA coefficients (a∗0 . . . ), (b∗0 . . . ) in Eq. (2)11 :
∞
 ∞
 offshore market. In addition, the bid-ask spread and percentage
αj = − a∗k , βj = − b∗k .
k= j+1 k= j+1
When the coefficients appear in Eq. (4) and we drop the ηt terms,
the result is an identification-invariant, best-linear estimate of st ,
conditional on current and lagged vt . The pricing error variance
(σs2 ) then may be computed as
∞ 
 
  α has smaller pricing errors and standardized pricing errors than the
σ =2
αj β j cov(v ) j .
s βj
j=0
Initially, by using one-minute price and trade, we examine the
pricing error variance (σs2 ), which serves as the proxy for the de-
gree of market information efficiency for two sub-periods (before
and after SDR inclusion). To assure meaningful comparisons, we
10
We use the tick rule to classify trades as buyer-initiated (+1) or seller-initiated
(−1); this classification is based on price movements relative to previous trades. If
the transaction price is above (below) the previous price, we classify this transac-
tion as a buyer- (seller-) initiated trade. If there is no price change, we exclude that
trade. According to Finucane (20 0 0), when zero-tick trades are removed, the tick
rule provides more accurate measures than other trade classification algorithms do.
11
To address the pricing error approach explicitly, we consider a special case
with pricing error (st ) and an efficient price (random walk, mt ): pt = mt + st ,
mt = mt−1 + wt , and st = α wt + ηt , where wt are uncorrelated increments, and ηt
is a disturbance uncorrelated with wt , according to the work of Hasbrouck (1993).
This setting may be thought of as information-correlated (α wt ) and information-
uncorrelated (ηt ). Information-correlated pricing errors arise from adverse-selection
effects, and information-uncorrelated pricing errors may result from price discrete-
ness and noise trading. The return model is rt = pt − pt−1 = (mt − mt−1 ) + (st −
st−1 ) = wt + (α wt + ηt − α wt−1 + ηt−1 ).To estimate st and σs2 , it is necessary to con-
nect the model to the observable data. We assume that rt may be represented
as a first-order moving average process, rt = vt − βvt−1 (i.e., the rt equation in
VMA), and vt is the zero mean and serially uncorrelated disturbance. Two pa-
rameters, β and σv2 , fully characterize the mean and autocovariances of the re-
turn process. However, deriving the model requires the specification of three pa-
rameters, α , σw2 , and ση2 and therefore, the model is underidentified.We adopt
the common identification restriction (Beveridge and Nelson, 1981) to set ηt = 0
(i.e., the pricing error is entirely information-correlated; Hasbrouck, 1993). Due to
Beveridge and Nelson (1981)’s restriction (ηt = 0), the return model transfers to
rt = wt + α wt − α wt−1 = vt − βvt−1 . This transfer further implies α = β /(1 − β )vt ,
st = α wt = 1−ββ (1 − β )vt = βvt , and σs = β 2 σv2 . Under the Beveridge and Nelson re-
striction, this estimate is exact and can be applied to the more general situations.
Journal of Banking and Finance 127 (2021) 106124
also standardize σs2 by the sum of random walk component vari-
ance and pricing error variance, σm2 + σs2 .12 A lower (standard-
ized) pricing error variance implies better price efficiency for the
USD/CNH or USD/CNY market. For subsequent SDR inclusion event
σs2
study analyses, we also estimate σs2 and on a daily basis
(σs2 +σm2 )
around the SDR event.
Many previous studies of market efficiency use variance ratios
(2) to test whether prices follow a random walk (Boehmer and Kel-
ley (2009); Kaul and Sapp (2009)). A random walk implies that the
ratio of long-term to short-term return variances, measured per
unit time, equals 1. We compute |1 − V R(n, m )| for USD/CNH and
USD/CNY price returns to compare price efficiency, where V R(n, m )
is the ratio of the prices’ return variance over m periods to the
prices’ return variance over n periods, both divided by the length
of the period. Smaller |1 − V R(n, m )| represents better market ef-
(3) ficiency. We consider intraday measures based on ratios of (1, 2 ),
(1, 5 ), (1, 10 ), and (1, 20 ) to compare the price efficiency for two
markets before and after SDR inclusion, according to the analysis
of Boehmer and Kelley (2009). We also re-estimate |1 − V R(n, m )|
for USD/CNH and USD/CNY price returns on a daily basis for the
SDR event study analyses in the next section.
Table 2 shows the average bid-ask spreads, pricing errors, and
variance ratios in the onshore and offshore markets during the
sub-periods (before and after the SDR implementation day). In
Panel A of Table 2, over both periods, the offshore market has
a smaller bid-ask spread and percentage bid-ask spread than the
onshore market, suggesting the relatively higher liquidity in the
(4) bid-ask spread all decline significantly after the SDR inclusion in
both the onshore and offshore markets, indicating that liquidity
improves in both markets. After the inclusion of RMB in SDR, more
traders had incentives to include the RMB onshore and offshore as-
sets in their asset allocations and exchange USD/CNY and USD/CNH
rates, enhancing liquidity in both markets.
In Panel B of Table 2, over both periods, the offshore market
(5)
onshore market, suggesting the less regulated offshore market is
more efficient in general. In Panel C of Table 2, variance ratios mea-
sures (|1 − V R(n, m )| ) based on ratios of (1, 2), (1, 5), (1, 10), and
(1, 20) minutes show a consistent result: offshore market prices
are closer to a random walk and are more efficient. In addition, the
pricing errors, standardized pricing errors, and variance ratio mea-
sures all declined significantly after the SDR inclusion in both the
onshore and offshore markets, suggesting that price efficiency im-
proves in both markets. That is, after the inclusion of RMB in SDR,
more traders had incentives to include the RMB onshore and off-
shore assets in their asset allocations, benefiting price discovery in
both markets simultaneously (Ranaldo and Santucci de Magistris,
2019; Boehmer and Kelley, 2009).
3.2. Price discovery around the SDR implementation and
announcement days
To check whether the improvement of price efficiency in both
onshore and offshore markets can be attributed solely to SDR in-
clusion, we examine the pricing error and variance ratio measure-
ments on a daily basis for both RMB markets surrounding the SDR
announcement day (2015-11-30) and implementation day (2016-
10-01). We present the daily (standardized) pricing errors from 20
days before the SDR implementation (and announcement) to 20
days after in Fig. 2. Panels (2.a) and (2.b) in Fig. 2 reveal the lack of
12
According to Hasbrouck (1993),random walk component variance can be ex-
 ∗
 ∗  ∗ a
amined by σm2 = [ ai bi cov(v )  ∗i .
bi
5
Y.-L. Chen and K. Xu Journal of Banking and Finance 127 (2021) 106124

Table 2
Liquidity, pricing errors and variance ratios for USD/CNY (Onshore) and USD/CNH (Offshore) markets before and after SDR implementation day.

Bid-ask spread Percentage bid-ask spread

Onshore Offshore Onshore Offshore

Panel A Liquidity for USD/CNY (onshore) and USD/CNH (offshore) markets

Before SDR 0.0024 0.0012 0.0004 0.0002
After SDR 0.0014 0.0008 0.0002 0.0001
σ 2
Pricing errors (σs2 ) Standardized pricing errors ( σ 2 +σ 2 ) s
( s m)
Onshore Offshore Onshore Offshore
Panel B Pricing errors for USD/CNY (onshore) and USD/CNH (offshore) markets
Before SDR 0.2170 0.0005 0.6603 0.0028
After SDR 0.0850 0.0002 0.3300 0.0008
|1 − V R ( 1, 2 )| |1 − V R ( 1, 5 )| | 1 − V R(1, 10 ) |1 − V R(1, 20 )|
Onshore Offshore Onshore Offshore Onshore Offshore Onshore Offshore
Panel C Variance ratios for USD/CNY (onshore) and USD/CNH (offshore) markets
Before SDR 0.538 0.044 0.648 0.053 0.752 0.063 0.808 0.085
After SDR 0.429 0.018 0.528 0.020 0.605 0.031 0.652 0.033

Notes: This table reports the daily averages of bid-ask spreads, pricing errors (Hasbrouck, 1993) and variance ratios (Boehmer and Kelley, 2009) for USD/CNY
and USD/CNH markets over the two subperiods before SDR (July 1, 2014, to September 30, 2016) and after SDR (October 1, 2016, to December 31, 2018). Bid-ask
spread is the difference between ask and bid quotes in dollar value. We obtain the percentage bid-ask spread by dividing the bid-ask spread by the midpoint
σs2
of the bid and ask quotes. σs2 is the pricing error variance measurement based on Hasbrouck (1993), and is the relative mispricing measurement,
(σs2 +σm2 )
examined by the pricing error as a fraction of total price. The values of σ and σ are multiplied by 10 . We compute |1 − V R(n, m )| for USD/CNH and
s
2 2
m
7

USD/CNY returns to compare price efficiency, where V R (n, m ) is the ratio of the prices’ return variance over m periods to the prices’ return variance over n
periods, both divided by the length of the period.

Fig. 2. Pricing errors of USD/RMB surrounding SDR event day. Notes: These figures illustrate the impact of including the RMB in the SDR on the (standardized) pricing errors
in USD/CNH and USD/CNY markets. We calculate daily pricing errors (Hasbrouck, 1993) in USD/CNH and USD/CNY markets from 20 days before the execution (announcement)
day to 20 days after. The horizontal axis represents days from the execution (announcement) date. Pricing errors are calculated from one-minute rates of USD/CNY and
USD/CNH.

6
Y.-L. Chen and K. Xu Journal of Banking and Finance 127 (2021) 106124

Fig. 3. Variance ratios of USD/RMB surrounding SDR event day. Notes: These figures illustrate the impact of the including the RMB in the SDR on the variance ratios in
USD/CNH and USD/CNY markets. We calculate daily variance ratios (Boehmer and Kelley, 2009) in USD/CNH and USD/CNY markets from 20 days before the execution
(announcement) day to 20 days after. We compute |1 − V R(n, m )| for USD/CNH and USD/CNY returns to compare price efficiency, where V R(n, m ) is the ratio of the prices’
return variance over m periods to the prices’ return variance over n periods, both divided by the length of the period. The horizontal axis represents days from the execution
(announcement) date. Variance ratios are calculated from one-minute rates of USD/CNY and USD/CNH.

significant change for the (standardized) pricing errors of offshore
USD/CNH (blue dash line) and onshore USD/CNY (red solid line)
before and after SDR announcement day. However, in Panels (2.c)
and (2.d), we note a significant reduction of (standardized) pricing
errors after SDR implementation day, in contrast with before SDR.
Fig. 3 shows the daily variance ratio measures |1 − V R(1, 2 )|
and |1 − V R(1, 5 )| for offshore and onshore markets from 20 days
before the SDR implementation (and announcement) to 20 days af-
ter.13 Consistent with Fig. 2, Panels (3.a) and (3.b) in Fig. 3 show
no significant change for the variance ratios (1, 2) and (1, 5) of
offshore USD/CNH and onshore USD/CNY before and after the SDR
announcement day. There is a significant reduction of variance ra-
tios in both markets after the SDR implementation day, in contrast
with before SDR, in Panels (3.c) and (3.d).
In addition, we test for the difference between two means
of price efficiency measurements of USD/CNH and USD/CNY mar-
kets before-after the SDR event. We use one-minute USD/CNH and
USD/CNY prices to estimate price efficiency on a daily basis and
expect to find significantly smaller pricing error and variance ra-
tio measurements after the SDR implementation day. Table 3 re-
ports estimation results for the means of price efficiency measure-
ments of USD/CNH and USD/CNY markets before [−20, −1] and
after [+1, +20] the SDR announcement (implementation) day, as
well as the tests for the difference of before-after price efficiency
13
Due to space constraints, we do not show the variance ratios measures based
on ratios of (1, 10) and (1, 20) minutes for offshore and onshore markets in the fol-
lowing analysis. They show the consistent patterns and results with variance ratios
(1, 2) and (1, 5) and are available on request.
measurements for USD/CNH and USD/CNY markets. Different price
efficiency measurements include pricing errors, standardized pric-
ing errors, |1 − V R(1, 2 )|, and |1 − V R(1, 5 )|, as we report in Panels
A to D of Table 3.
Panel A shows that the means of pricing errors for the onshore
USD/CNY market before and after the SDR announcement day are
0.154 and 0.147, whereas for the offshore USD/CNH market, they
are 0.0 0 06 and 0.0 0 05. There are insignificant reductions in pric-
ing errors for onshore (0.007) and offshore (0.0 0 01) markets from
before to after the SDR announcement day. In contrast, the means
of pricing errors for the onshore USD/CNY market before and after
the SDR implementation day are 0.146 and 0.053, and those for the
offshore USD/CNH market are 0.0 0 06 and 0.0 0 01. There are signif-
icantly smaller pricing errors in both onshore and offshore mar-
kets after the SDR implementation day, compared to before, be-
cause the t-statistics for the difference in means before and after
the SDR implementation day for onshore and offshore markets are
15.776 and 7.730.
Panel B of Table 3 shows that the means of standardized pric-
ing errors for the onshore USD/CNY market before and after the
SDR announcement day are 0.732 and 0.642, and those for the off-
shore USD/CNH market are 0.0 056 and 0.0 031. There is a signifi-
cant reduction in standardized pricing errors for the onshore mar-
ket, but it is insignificant for the offshore market, from before to
after the SDR announcement day. The significantly smaller pricing
errors in both onshore and offshore markets after the SDR imple-
mentation day, compared to before, are consistent with the results
in Panel A of Table 3. In Panels C and D of Table 3, the variance
ratio measures based on ratios of (1, 2 ) and (1, 5 ) minutes show

7
Y.-L. Chen and K. Xu Journal of Banking and Finance 127 (2021) 106124

Table 3
Pricing errors and variance ratios for USD/CNY and USD/CNH markets around SDR announcement and implementation days.

SDR announcement day SDR implementation day

Onshore Offshore Diff = Onshore-Offshore Onshore Offshore Diff = Onshore-Offshore

Panel A: Pricing errors for onshore and offshore markets before and after SDR announcement (implementation) day [(20, +20) trading days]
Before SDR 0.154 0.0006 0.153∗ ∗ ∗ (20.716) 0.146 0.0006 0.145∗ ∗ ∗ (25.422)
After SDR 0.147 0.0005 0.147∗ ∗ ∗ (23.281) 0.053 0.0001 0.053∗ ∗ ∗ (38.064)
Diff = Before-After 0.007 (0.706) 0.0001 (0.655) 0.007 (0.697) 0.093∗ ∗ ∗ (15.776) 0.0005∗ ∗ ∗ (7.730) 0.092∗ ∗ ∗ (17.154)
SDR announcement day SDR implementation day

Onshore Offshore Diff = Onshore-Offshore Onshore Offshore Diff = Onshore-Offshore

Panel B: Standardized pricing errors for onshore and offshore markets before and after SDR announcement (implementation) days [(20, +20) trading days]
Before SDR 0.732 0.0056 0.726∗ ∗ ∗ (21.285) 0.675 0.0035 0.672∗ ∗ ∗ (54.117)
After SDR 0.642 0.0031 0.639∗ ∗ ∗ (39.438) 0.375 0.0002 0.375∗ ∗ ∗ (40.770)
Diff = Before-After 0.090∗ ∗ (2.502) 0.0025 (0.980) 0.088∗ ∗ ∗ (3.405) 0.300∗ ∗ ∗ (19.476) 0.0033∗ ∗ ∗ (8.609) 0.297∗ ∗ ∗ (16.577)
SDR announcement day SDR implementation day

Onshore Offshore Diff = Onshore-Offshore Onshore Offshore Diff = Onshore-Offshore

Panel C: |1 − V R(1, 2 )| for onshore and offshore markets before and after SDR announcement (implementation) days [(20, +20) trading days]
Before SDR 0.480 0.126 0.354∗ ∗ ∗ (19.316) 0.424 0.091 0.333∗ ∗ ∗ (25.470)
After SDR 0.410 0.098 0.312∗ ∗ ∗ (18.248) 0.293 0.035 0.258∗ ∗ ∗ (28.397)
Diff = Before-After 0.070∗ ∗ ∗ (3.444) 0.028∗ (1.914) 0.042 (1.557) 0.131∗ ∗ ∗ (10.313) 0.056∗ ∗ ∗ (5.892) 0.075∗ ∗ ∗ (4.383)
SDR announcement day SDR implementation day

Onshore Offshore Diff = Onshore-Offshore Onshore Offshore Diff = Onshore-Offshore

Panel D: |1 − V R(1, 5 )| for onshore and offshore markets before and after SDR announcement (implementation) days [(20, +20) trading days]
Before SDR 0.649 0.147 0.502∗ ∗ ∗ (27.399) 0.644 0.121 0.523∗ ∗ ∗ (28.896)
After SDR 0.643 0.142 0.501∗ ∗ ∗ (24.985) 0.508 0.064 0.444∗ ∗ ∗ (40.129)
Diff = Before-After 0.006 (0.297) 0.005 (0.346) 0.001 (0.027) 0.136∗ ∗ ∗ (7.908) 0.057∗ ∗ ∗ (5.129) 0.079∗ ∗ ∗ (4.557)

Notes: This table reports the average values of daily (standardized) pricing errors and variance ratios for USD/CNY (onshore) and USD/CNH (offshore) markets from
20 days before the SDR announcement (implementation) to 20 days after. The inclusion of RMB in SDR basket was announced on 2015-11-30 and implemented
σs2
on 2016-10-01. The pricing error variance measurement is based on Hasbrouck (1993), and the standardized pricing error is calculated as , which is the
(σs2 +σm2 )
relative mispricing measurement, examined by the pricing error as a fraction of total price. We report |1 − V R(n, m )| for USD/CNH and USD/CNY returns to compare
price efficiency, where V R(n, m ) is the ratio of the prices’ return variance over m periods to the prices’ return variance over n periods, both divided by the length
of the period. The t-statistics in parentheses for the Diff category test the null hypotheses that the differences in before-after and onshore-offshore are equal to 0
across SDR implementation and announcement days. ∗ ∗ ∗ , ∗ ∗ , and ∗ indicate significance at the 1%, 5%, and 10% levels, respectively.

consistent results, in support of the significantly smaller variance
ratio measurements after the SDR implementation, compared with
before the SDR implementation day.
From the mean differences of price efficiency measurements
between onshore and offshore markets, we find a significantly
lower value in the offshore market than in the onshore market in
Table 3, supporting the dominance of the offshore market in price
discovery. Before the SDR implementation day, the mean difference
of price error in onshore-offshore markets is 0.145, whereas it is
0.053 after the SDR implementation in Panel A of Table 3. Panels
B to D of Table 3 also show that the mean difference of price ef-
ficiency in onshore-offshore markets shrinks after the SDR imple-
mentation, compared with before. This result may imply that af-
ter the SDR implementation, both RMB onshore and offshore prices
became better integrated.
Finally, to confirm whether the liquidity in both onshore and
offshore markets is enhanced after SDR inclusion, we also exam-
ine the changes in bid-ask spread and percentage bid-ask spread in
the onshore and offshore markets surrounding the SDR announce-
ment day and implementation day. Panel A of Table 4 shows that
the means of bid-ask spread for the onshore USD/CNY market be-
fore and after the SDR announcement day are 0.0029 and 0.0025,
whereas for the offshore USD/CNH market, they are 0.0010 and
0.0 0 08. In addition, the means of bid-ask spread for the onshore
USD/CNY market before and after the SDR implementation day
are 0.0024 and 0.0020, whereas for the offshore USD/CNH market,
they are 0.0 0 04 and 0.0 0 03. In Panel B of Table 4, the percentage
bid-ask spreads show consistent results, in support of the signifi-
cantly smaller percentage bid-ask spreads after the SDR implemen-
tation, compared with before the SDR implementation day. These
results confirm that more traders had incentives to trade USD/CNH
and USD/CNY rates after the inclusion of RMB in SDR. Higher liq-
uidity begets price efficiency by systematically reducing pricing er-
rors and facilitating information integration processing (Ranaldo
and Santucci de Magistris, 2019; Boehmer and Kelley, 2009).
3.3. Price discovery placebo test
To distinguish the effect of SDR inclusion from the overall time
trend, we use placebo tests, in which we randomly choose some
time points and compare the price efficiency measures before and
after the randomly chosen points.14 If the improvement of price
efficiency can be attributed solely to the SDR implementation (an-
nouncement), we will not observe any significant change in the
price efficiency measures before-after random chosen points. We
consider the pseudo-announcement (pseudo-implementation) day
to be two months before the SDR announcement (implementation)
day, which is on 2015-09-30 (2016-08-01), then repeat the before-
after price efficiency analysis.
The results of the placebo test show in Panel A of Table 5 that
the means of pricing errors for the onshore USD/CNY market be-
fore and after the SDR announcement day are 0.132 and 0.154,
and those for the offshore USD/CNH market are 0.0011 and
0.0010. There are insignificant changes in pricing errors for onshore
(−0.022) and offshore (0.0 0 01) markets from the before-pseudo-
announcement to after-pseudo-announcement day. The means of
pricing errors for the onshore USD/CNY market before and after
the pseudo-implementation day are 0.184 and 0.135, and those for
the offshore USD/CNH market are 0.0 0 08 and 0.0 0 06. There are
insignificant changes in the pricing errors for onshore (0.049) and
14
We thank an anonymous reviewer for suggesting the use of placebo tests to
check whether the improvement of price efficiency can be attributed solely to the
SDR inclusion.

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Y.-L. Chen and K. Xu Journal of Banking and Finance 127 (2021) 106124

Table 4
Liquidity for USD/CNY (onshore) and USD/CNH (offshore) markets around SDR announcement and implementation days.

SDR announcement day SDR implementation day

Onshore Offshore Diff = Onshore-Offshore Onshore Offshore Diff = Onshore-Offshore

Panel A: Bid-ask spread for onshore and offshore markets before and after SDR announcement (implementation) day [(20, +20) trading days]
Before SDR 0.0029 0.0010 0.0019∗ ∗ ∗ (46.864) 0.0024 0.0004 0.0020∗ ∗ ∗ (66.447)
After SDR 0.0025 0.0008 0.0017∗ ∗ ∗ (53.741) 0.0020 0.0003 0.0017∗ ∗ ∗ (53.404)
∗∗∗
Diff = Before-After 0.0004 (9.394) 0.0002∗ ∗ ∗ (14.609) 0.0002∗ (1.875) 0.0004∗ ∗ ∗ (9.892) 0.0001∗ ∗ ∗ (6.260) 0.0003∗ ∗ ∗ (11.196)
SDR announcement day SDR implementation day

Onshore Offshore Diff = Onshore-Offshore Onshore Offshore Diff = Onshore-Offshore

Panel B: Percentage bid-ask spread for onshore and offshore markets before and after SDR announcement (implementation) days [(20, +20) trading days]
Before SDR 0.0005 0.0001 0.0004∗ ∗ ∗ (54.072) 0.0004 0.0001 0.0003∗ ∗ ∗ (66.372)
After SDR 0.0004 0.0001 0.0003∗ ∗ ∗ (46.945) 0.0003 0.0001 0.0002∗ ∗ ∗ (53.437)
∗∗∗ ∗∗∗ ∗∗∗
Diff = Before-After 0.0001 (8.582) 0.0000 (13.656) 0.0000 (1.494) 0.0001 (9.490) 0.0000∗ ∗ ∗ (6.495) 0.0001∗ ∗ ∗ (10.924)

Notes: This table reports the average values of one-minute bid-ask spread and percentage bid-ask spread for USD/CNY (onshore) and USD/CNH (offshore) markets from
20 days before the SDR announcement (implementation) to 20 days after. The inclusion of RMB in SDR basket was announced on 2015-11-30 and implemented on 2016-
10-01. Bid-ask spread is the difference between ask and bid quotes in dollar value. We obtain the percentage spread bid-ask spread by dividing the bid-ask spread by the
midpoint of the bid and ask quotes. The t-statistics in parentheses for the Diff category test the null hypotheses that the differences in before-after and onshore-offshore
are equal to 0 across SDR implementation and announcement days. ∗ ∗ ∗ , ∗ ∗ , and ∗ indicate significance at the 1%, 5%, and 10% levels, respectively.

offshore (0.0 0 02) markets from the before-pseudo-implementation ciated with an I (1 ) process. We then plot the autocorrelation func-
to after-pseudo-implementation day. The t-statistics for the differ- tion for the error correction term, β  Zt , in Fig. 4c. The correlogram
ence in means before and after pseudo-implementation day for on- of the error correction term decays much faster with long-term cy-
shore and offshore markets are 1.280 and 0.816. cles in its autocorrelations, which is a clear feature of long memory
In Panels B to D of Table 5, we find similar results, in sup- processes. This evidence motivates our use of the FCVAR model.
port of insignificant change in standardized pricing errors and vari- We first review the non-fractional CVAR model, then show how
ance ratios based on ratios of (1, 2 ) and (1, 5 ) minute measure- to generalize it to FCVAR. Let Yt , t = 1, . . . , T , be a p-dimensional
ments for after-pseudo-announcement day, compared with before- I (1 ) time series. The CVAR model is
pseudo-announcement day. There are also insignificant changes in

k 
k
the standardized pricing errors and variance ratios based on ra- Yt = αβ Yt−1 + i Yt−i + εt = αβ  LYt + i LiYt + εt , (6)
tios of (1, 2 ) and (1, 5 ) minute measurements from the before- i=1 i=1
pseudo-implementation to the after-pseudo-implementation day. where εt is p-dimensional independent and identically distributed
These findings confirm that our results regarding the improvement with 0 mean and covariance matrix . We derive the FCVAR model
of price efficiency in onshore and offshore RMB markets are at- by replacing the difference and lag operators,  and L, with their
tributable to the SDR inclusion effect. fractional counterparts, b and Lb = 1 − b , to get

k
3.4. A fractional cointegrated VAR analysis of price discovery bYt = αβ  LbYt + i b LibYt + εt . (7)
i=1
In this section, we apply the fractional cointegrated VAR (FC-
If we let Yt = d−b Zt , we obtain the FCVAR model,
VAR) model to study the price dynamics in the RMB onshore
and offshore markets.15 In equilibrium relationships across foreign 
k

exchange markets, fractional integration (or long memory) may
emerge (Baillie and Bollerslev, 1994; Gil-Alana and Carcel, 2018),
which would imply fractional cointegration among the exchange
rates. Furthermore, long memory characteristics may mean that an
error correction term responds slowly to shocks, so deviations from
equilibrium persist, and the equilibrium error is more substantial.
Even if the exchange rates are I (1 ), β  Zt is fractionally integrated
at a lower order between 0 and 1. According to Baillie and Boller-
slev (1994), the error correction term of six exchange rates, β  Zt ,
exhibits long memory characteristics. They also argue that the au-
tocorrelation coefficients of the error correction term decay slowly.
Following Baillie and Bollerslev (1994), we plot the first 60 0 0
autocorrelation coefficients of the USD/CNY and USD/CNH rates in
Fig. 4a and b. The correlograms exhibit a very gradual decline asso-
15
In the framework of price change and trade dynamics in a single market
(Hasbrouck, 1993), the trades (or orders) are allowed to be endogenous; they are
related to the previous price changes and trades. The model of Hasbrouck (1993) as-
sumes that a single observed security price impounds an implicit efficient price, and
attributes the sources of variation in this efficient price to trades. Here, the follow-
ing CVAR or FCVAR analysis can be viewed as a multiple market extension in which
the implicit efficient price is common to all markets, and the sources of variation
in this efficient price are attributed to different markets. We suggest the potential
extension in future studies to consider the trade role in multiple markets with com-
mon efficient price to examine price discovery, especially the multiple prices with
fractional integration.
d Zt = αβ  Lb d−b Zt + i d Lib Zt + εt . (8)
i=1
The parameters α and β have the same interpretations in both
models, such that α and β are p × r matrices with 0 ≤ r ≤ p,
where r represents cointegration rank. The columns of β are the
cointegrating vectors that represent the long-run equilibrium rela-
tions. The coefficients in α are the adjustment coefficients, measur-
ing the speed of adjustment toward equilibrium. The parameters i
show the short-run dynamics of the time series variables.
The two additional parameters d and b in the FCVAR model de-
note the fractional integration order of the observable time series
and the degree of fractional cointegration. The cointegrating vec-
tor β  Zt is of order I (d − b) (I (0 )) in the FCVAR (CVAR) model.
We assume that d = 1 and focus on estimating the parameter b.
This property of exchange rates being I (1 ) has become generally
accepted (Baillie and Bollerslev, 1994; Diebold et al., 1994).
For the special case of b = 1, the FCVAR model reduces to the
CVAR model. Thus, in addition to modeling long-run equilibria,
adjustment responses to deviations from the equilibria, and the
short-run dynamics of the system, the fractional parameter b can
evaluate the degree of fractional cointegration to reveal the long
memory properties of the cointegration errors. As b increases, the
model converges to the non-fractional CVAR model. Higher val-
ues of b imply less memory in the error correction term, and the
two markets are better integrated, so when b increases, it signals

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Y.-L. Chen and K. Xu Journal of Banking and Finance 127 (2021) 106124

Table 5
Placebo tests for USD/CNY (Onshore) and USD/CNH (Offshore) markets prices efficiency around pseudo-event day.

Before SDR announcement day (Pseudo-event day: 2015-09-30) Before SDR implementation day (Pseudo-event day: 2016-08-01)

Onshore Offshore Diff = Onshore-Offshore Onshore Offshore Diff = Onshore-Offshore

Panel A: Pricing errors before and after pseudo-event [(−20, +20 ) trading days]
Before pseudo-event day 0.132 0.0011 0.131∗ ∗ ∗ (4.842) 0.184 0.0008 0.183∗ ∗ ∗ (9.645)
After pseudo-event day 0.154 0.0010 0.153∗ ∗ ∗ (3.656) 0.135 0.0006 0.134∗ ∗ ∗ (3.996)
Diff = Before-After −0.022 (−0.435) 0.0001 (1.022) −0.022 (−0.433) 0.049 (1.280) 0.0002 (0.816) 0.049 (1.053)
Before SDR announcement day (Pseudo-event day: 2015-09-30) Before SDR implementation day (Pseudo-event day: 2016-08-01)

Onshore Offshore Diff = Onshore-Offshore Onshore Offshore Diff = Onshore-Offshore

Panel B: Standardized pricing errors before and after pseudo-event [ (−20, +20 ) trading days]
Before pseudo-event day 0.642 0.0020 0.640∗ ∗ ∗ (13.298) 0.740 0.0022 0.738∗ ∗ ∗ (11.583)
After pseudo-event day 0.666 0.0022 0.663∗ ∗ ∗ (16.081) 0.721 0.0021 0.719∗ ∗ ∗ (14.190)
Diff = Before-After −0.024 (−0.371) −0.0002 (−0.292) −0.023 (−0.414) 0.019 (0.332) 0.0001 (0.303) 0.019 (0.324)
Before SDR announcement day (Pseudo-event day: 2015-09-30) Before SDR implementation day (Pseudo-event day: 2016-08-01)

Onshore Offshore Diff = Onshore-Offshore Onshore Offshore Diff = Onshore-Offshore

Panel C: |1 − V R(1, 2 )| for before and after pseudo-event [(20, +20) trading days]
Before pseudo-event day 0.319 0.108 0.211∗ ∗ ∗ (5.599) 0.386 0.067 0.319∗ ∗ ∗ (13.670)
After pseudo-event day 0.345 0.084 0.261∗ ∗ ∗ (5.698) 0.343 0.055 0.288∗ ∗ ∗ (9.867)
Diff = Before-After −0.026 (−0.479) 0.024 (0.855) −0.050 (−0.763) 0.043 (1.304) 0.012 (0.687) 0.031 (0.860)
Before SDR announcement day (Pseudo-event day: 2015-09-30) Before SDR implementation day (Pseudo-event day: 2016-08-01)

Onshore Offshore Diff = Onshore-Offshore Onshore Offshore Diff = Onshore-Offshore

Panel D: |1 − V R(1, 5 )| before and after pseudo-event [(20, +20) trading days]
Before pseudo-event day 0.550 0.184 0.366∗ ∗ ∗ (5.538) 0.604 0.122 0.482∗ ∗ ∗ (12.125)
After pseudo-event day 0.560 0.157 0.403∗ ∗ ∗ (5.967) 0.570 0.154 0.416∗ ∗ ∗ (8.893)
Diff = Before-After −0.010 (−0.131) 0.027 (0.498) −0.037 (−0.362) 0.034 (0.675) −0.032 (−0.923) 0.066 (1.208)

Notes: This table reports the average values of daily (standardized) pricing errors and variance ratios for USD/CNY (onshore) and USD/CNH (offshore) markets from 20
days before the pseudo-event day to 20 days after. We consider the pseudo-announcement (pseudo-implementation) day to be two months before the SDR announcement
(implementation) day, which is on 2015-09-30 (2016-08-01). The pricing error variance measurement is based on Hasbrouck (1993), and the standardized pricing error is
σs2
calculated as , which is the relative mispricing measurement, examined by the pricing error as a fraction of total price. We report |1 − V R(n, m )| for USD/CNH and
(σs2 +σm2 )
USD/CNY returns to compare price efficiency, where V R(n, m ) is the ratio of the prices’ return variance over m periods to the prices’ return variance over n periods, both
divided by the length of the period. The t-statistics in parentheses for the Diff category test the null hypotheses that the differences in before-after and onshore-offshore
are equal to 0. ∗ ∗ ∗ , ∗ ∗ , and ∗ indicate significance at the 1%, 5%, and 10% levels, respectively.

stronger overall price efficiency in both the onshore and offshore
RMB markets.
Following Dolatabadi et al. (2016), we estimate the error cor-
rection equation,

k
Zt = α Lb 1−b (β  Zt − ρ  πt (1 )) + i Lib Zt + ξ πt (1 ) + εt ,
i=1
(9)
where Zt = (PtCNY , PtCNH ), b is the fractional parameter, ρ is the
mean of the cointegration vector β  Zt , and ξ represents a linear
deterministic trend in the levels of the variables. The parameters α
and β have the same interpretations as in the non-fractional CVAR
model, such that α and β are p × r matrices with 0 ≤ r ≤ p, where
r represents cointegration rank. The columns of β are the coin-
tegrating vectors that represent the long-run equilibrium relations.
The coefficients in α are the adjustment coefficients, measuring the
speed of adjustment toward equilibrium. The parameters i show
the short-run dynamics of the time series variables. Eq. (9) con-
tains both a restricted constant ρ  πt (1 ) and an unrestricted con-
stant ξ πt (1 ), in the terminology of Johansen (1995).16
A FCVAR model not only encompasses the features of a non-
fractional CVAR model but also allows long memory features in
the error correction term. The ability to establish this extended
model emerged from recent developments of the asymptotic the-
ory for estimation and inference in the FCVAR model. Specifically,
16
The fractional coefficients πn (u ) are defined in terms of the binomial expansion
∞
(1 − z )−u = n=0 πn (u )z , such that
n
Johansen and Nielsen (2010, 2012, 2016, 2019) reveal asymptotic
distribution results for maximum likelihood estimators and likeli-
hood ratio tests for cointegration ranks.
Following Dolatabadi et al. (2015), we choose the optimal lag
length k = 14 and the cointegration rank r = 1 for both subsam-
ple periods before and after SDR.17 The cointegrating vector β  Zt
is of order I (1 − b) (I (0 )) in the FCVAR (CVAR) model. We focus
on the estimation of the fractional parameter b, adjustment coef-
ficients α , and proportional price discovery contribution in each
market.18 The FCVAR and CVAR estimation results are presented in
Table 6. Compared with the results from the non-fractional CVAR
model, we find slightly less price discovery in the offshore market,
in terms of relative price discovery. When allowing for fractional
cointegration, we find that the estimate of b increased after SDR,
which implies that joint price efficiency in the onshore and off-
shore markets has improved after the implementation of SDR. The
non-fractional CVAR model restricted b to equal 1, so it is silent
about the absolute price efficiency changes in the onshore and off-
shore markets around SDR.
Relative price discovery can be analyzed in the FCVAR model
the same way as in the CVAR model, by examining the adjust-
ment coefficients. In Table 6, we provide the estimation results for
b and the relative price discovery contributions for the USD/CNY
(onshore) and USD/CNH (offshore) markets, using the FCVAR and
CVAR models. The empirical results in Table 6 represent the two
different sample periods: before and after SDR implementation.
Compared with the non-fractional CVAR model results, both mod-
els reveal that the offshore market dominates the price discovery

u (u + 1 ) . . . (u + n − 1 )
πn ( u ) = (10) 17
See Dolatabadi et al. (2015) for model selection details. Results on lag selection
n! and cointegration rank tests are available upon request.
18
Johansen and Nielsen (2016, Appendix A) provide more detailed intermediate re- Nielsen and Popiel (2018) provides the Matlab computer programs for calculat-
sults regarding this expansion and the fractional coefficients. ing estimators and test statistics.

10
Y.-L. Chen and K. Xu Journal of Banking and Finance 127 (2021) 106124

Fig. 4. Correlograms. Notes: This figure plots the first 60 0 0 autocorrelation coefficients of the USD/CNY and USD/CNH rates in Panel (a) and (b). Panel (c) plots the autocor-
relation function for the error correction term, β  Zt . Following Baillie and Bollerslev (1994), we estimate the cointegration vector, β , from an OLS regression of the logarithm
of the the USD/CNY rates on a constant and the logarithm of the USD/CNH rates. The solid blue lines plot the autocorrelation coefficients and the dashed red lines are error
bands with two standard deviations. The data are one-minute rates of USD/CNY and USD/CNH from July 2014 to December 2018. (For interpretation of the references to
color in this figure legend, the reader is referred to the web version of this article.)

process, in terms of relative price discovery. When allowing for
fractional cointegration, we find that the estimate of b increased
after SDR, which implies that joint price efficiency in the onshore
and offshore markets has improved after the implementation of
SDR. The non-fractional CVAR model restricted b to equal 1, so it
is silent about the absolute price efficiency changes in the onshore
and offshore markets around SDR.
Consistent with our results regarding the pricing error and vari-
ance ratio, the FCVAR estimation of b shows that the onshore and
offshore markets’ price efficiency has improved. When we only es-
timate the CVAR model, we cannot see the overall improvement in
market efficiency, because the CVAR model can only estimate the
relative price discovery in the onshore and offshore markets. In an-
alyzing the inclusion of RMB in SDR, we would miss the overall
increase in price efficiency in RMB markets if we were to estimate
only the CVAR model.
In addition to the pricing error and variance ratio measure-
ments, another significant contribution of the FCVAR model is that
it can estimate price efficiency in a joint bi-variate cointegration
setting. The information in both the onshore and offshore mar-
kets is considered in the joint estimation of the FCVAR model.
The pricing error and variance ratio can only evaluate price ef-
ficiency in each market separately and thus take into consider-
ation information in only one market at a time. When time se-
ries data present long memory properties, the single estimation of
the FCVAR can replace the multiple estimations of the CVAR, the
pricing error and variance ratio measures. The FCVAR model is a
more efficient way to analyze long memory time series data espe-

11
Y.-L. Chen and K. Xu Journal of Banking and Finance 127 (2021) 106124

Table 6
CVAR and FCVAR estimation results comparison.

Before SDR After SDR

CVAR FCVAR CVAR FCVAR

b 1 0.619 1 0.812
α (−0.000 0.001) (−0.002 0.028) (−0.002 0.000) (−0.007 0.000)
Price discovery (0.067 0.933) (0.078 0.922) (0.004 0.996) (0.070 0.930)
H α1 no (0.000) no (0.000) no (0.000) no (0.000)
H α2 yes (0.361) yes (0.263) yes (0.109) yes (0.395)
log(L ) 1801453.055 1801506.453 2460223.363 2460385.669

Notes: This table reports the CVAR and FCVAR estimation results for the two subsamples, before
SDR (July 2014–September 2016) and after SDR (October 2016–December 2018). We estimate

the following regression equation: Zt = α Lb 1−b (β  Zt − ρ  πt (1 )) + ki=1 i Lib Zt + ξ πt (1 ) +
εt , where b is the fractional parameter, so when b = 1, the FCVAR model reduces to the CVAR
model. In addition, α⊥ is a direct measure of the price discovery contributions of the onshore
and offshore markets. We normalize the price discovery of the two markets to be non-negative
numbers, adding up to 1, and report the price discovery contribution of the onshore market first,
followed by the offshore market. The next two rows in the table shows the hypothesis testing
results for α1 = 0 (offshore market does not contribute to price discovery at all) and α2 = 0 (on-
shore market does not contribute to price discovery at all). A ‘no’ indicates that the hypothesis
is rejected, and a ‘yes’ indicates non-rejection. The p-values for the hypothesis tests are reported
in parentheses. The last row reports the maximized likelihood for each model.

Table 7 ter. As a robustness check, we also report the relative root mean
Statistical out-of-sample forecast.
squared error (RMSE) from the CVAR and the FCVAR model fore-
CW Stat ist ics RelativeRMSE casts, calculated such that negative values favor the FCVAR model
Onshore Offshore Onshore Offshore forecasts.
The results of the CW statistics and relative RMSE clearly show
Panel A: CVAR and FCVAR comparison
Before SDR 3.3739 3.8197 −0.0899 −0.0152
that the FCVAR model outperforms the CVAR model in both the
After SDR 4.8402 5.5160 −0.0377 −0.0449 onshore and offshore markets, for the before and after SDR sample
R2 CVAR R2 FCVAR periods. Table 7, Panel B, contains the out-of-sample R2 in the on-
Onshore Offshore Onshore Offshore shore and offshore markets for both the CVAR and the FCVAR fore-
MSEP
Panel B: Out-of-sample R2 casts. The out-of-sample R2 is calculated as R2 = 1 − MSEM , where
Before SDR 0.2850 −0.0071 0.2863 −0.0068 MSEP is the mean squared error of the predicted returns, and
After SDR 0.0536 −0.0047 0.0543 −0.0038 MSEM measures the mean squared error in the observed data.
Notes: This table reports the out-of-sample forecasting perfor- In general, higher values of the out-of-sample R2 imply stronger
mance of the FCVAR and CVAR models using the sample before forecasting performance and weaker price efficiency. We note that
SDR (July 2014–September 2016) and after SDR (October 2016– the forecastability of returns varies greatly across the two sample
December 2018). Specifically, we recursively generate one-step
ahead return forecasts, re-estimating the model using the previ-
periods in the onshore market. The out-of-sample R2 is higher in
ous 60 0 0 observations for each new forecast. Panel A reports the the onshore market before SDR than after SDR, which implies that
out-of-sample forecast comparison statistics for one-step return the onshore market became more efficient (more difficult to fore-
forecasts between the CVAR and the FCVAR models. The statistics cast) as a result of SDR. The out-of-sample R2 in the offshore mar-
reported are the Clark and West (2007) (CW) test statistic, the
ket does not change much after SDR. When we consider the fore-
relative root mean square error (RMSE). Panel B reports the out-
of-sample R2 for the CVAR and FCVAR forecasts. The CW statistic cast performance in the two markets jointly, the out-of-sample R2
is asymptotically standard normally distributed, and positive val- is higher before SDR than after SDR. These findings are consistent
ues favor the FCVAR model. The relative RMSE is calculated such with our hypothesis that a higher estimate of fractional parame-
that it favors the FCVAR model when it is negative. ter b indicates better price efficiency, making it more difficult to
forecast returns after SDR.
cially when we are interested in both absolute and relative price
efficiency. 4. Discussion

3.5. Forecasting performance of the FCVAR and CVAR models
We next consider out-of-sample forecasting performance of the
FCVAR and CVAR models using the sample before and after the
SDR. Specifically, we recursively generate one-step ahead return
forecasts, re-estimating the model using the previous 60 0 0 obser-
vations for each new forecast.
In Table 7, Panel A, we present the out-of-sample forecast
comparisons between the CVAR and FCVAR models. We report
Clark and West (2007) (CW) test statistics for equal predictability
to account for the fact that the CVAR model is nested within the
FCVAR model. The CW statistic is asymptotically standard normally
distributed, and positive values would favor the FCVAR model. The
null hypothesis of the nested CW test is that the CVAR model fore-
casts are better than or as good as the FCVAR model forecasts; the
alternative hypothesis is that the FCVAR model forecasts are bet-
To consider the influence of adding RMB to the SDR basket, we
use an example of the Bank for International Settlements (BIS),
which manages its own capital, much of which is invested in
sovereign debt denominated in the constituent currencies of the
SDR. As of the end of March 2019, according to its annual report,
total assets stood at SDR 291.1 billion, up 13% from the previous
year, with net profits of SDR 461 million.
The banking services provided by BIS aim to meet the asset di-
versification demands of its global customer base. As Fig. 5 shows,
deposits from customers in the Asia-Pacific region are dominant;
most of its demand comes from this region. To address clients’
needs in these markets, BIS added a new money market and trad-
able instruments in offshore RMB (USD/CNH) to the product range
after its addition to the SDR. Moreover, new instruments, denomi-
nated in onshore RMB (USD/CNY), are under development. In 2016,
BIS also became one of the earliest offshore investors to trade in

12
Y.-L. Chen and K. Xu
Fig. 5. Geographical distribution of customer deposits of the Bank for International Settlements. Notes: This figure shows the geographical distribution of customer deposits
based on balance sheet values in SDR at the Bank for international Settlements (BIS) in different regions around the world. Source: The BIS 2019 Annual Report.
the onshore RMB market directly, through CFETS (China Foreign
Exchange Trade System).
It is one of many SDR users, and the RMB’s inclusion in the SDR
prompted many central banks, similar to BIS, to rebalance their
holding portfolios and upgrade their asset allocations by including
RMB. This RMB investment process in offshore and onshore mar-
kets should make the two exchange rates more efficient and lead
them to converge together. The high degree of RMB market inte-
gration also can help investors set up trading strategies, manage
their currency portfolios, and hedge their risk in the global mar-
ket.
Even if the RMB’s integration in the SDR basket may drive
changes in the currency allocations of traders, it still might not
affect the dominance of the U.S. dollar in international financial
systems. Even though the SDR was conceived of with the goal of
diversifying reserve allocations, it is still dominated by the dollar,
which is weighted far more heavily than other currencies in the
basket. Moreover, the RMB’s share of the SDR basket has been ac-
commodated by greater reductions in the weights of the euro and
the pound; the dollar’s weight remains virtually unchanged. Before
October 2016, the SDR weights were as follows: USD (41.9%), EUR
(37.4%), JPY (9.4%), and GBP (11.3%). After that, the new weights
became: USD (41.73%), EUR (30.93%), JPY (8.33%), GBP (8.09%), and
RMB (10.92%). The demand for the U.S. dollar is still strong and is
not affected by RMB’s arrival in the SDR.
5. Conclusion
This research applies the pricing error measurement, variance
ratio measurement, and FCVAR model to study the effect of RMB
inclusion in the SDR on price efficiency in onshore and offshore
markets. The results show that the offshore market is dominant
in the price discovery process. Including RMB in the SDR would
not affect the dominance of offshore market in price discovery. The
onshore (USD/CNY) and offshore (USD/CNH) prices are fractionally
cointegrated with long-run equilibrium errors that exhibits long
memory. The estimated fractional parameter increases after SDR,
which implies less memory in the long-run equilibrium errors be-
tween the onshore and offshore market prices after SDR. The frag-
mented markets become better integrated, and price efficiency im-
proves after SDR implementation. This improvement in price effi-
13
Journal of Banking and Finance 127 (2021) 106124
ciency cannot be revealed by the non-fractional CVAR model for
price discovery contribution. To the best of our knowledge, our
study is the first to provide the evidence of better market inte-
gration, higher prices efficiency, and fewer arbitrage opportunities
in RMB onshore and offshore markets after SDR inclusion.
Declaration of Competing Interest
Authors declare that they have no conflict of interest.
CRediT authorship contribution statement
Yu-Lun Chen: Conceptualization, Methodology, Software, Data
curation, Formal analysis, Investigation, Writing - original draft,
Writing - review & editing, Investigation, Visualization, Validation,
Project administration, Funding acquisition. Ke Xu: Conceptualiza-
tion, Methodology, Software, Investigation, Formal analysis, Inves-
tigation, Writing - original draft, Writing - review & editing, Visu-
alization, Validation, Project administration, Funding acquisition.
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