PRICE DISCOVERY IN CURRENCY MARKETS
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PRICE DISCOVERY IN CURRENCY MARKETS
Price Discovery in Currency MarketsCarol L. Osler. Brandeis University. USA* Alexander Mende, University of Hannover. Germany Lukas Menkhoff, Universi PRICE DISCOVERY IN CURRENCY MARKETSity of Hannover. GermanyAbstractThis paper makes three contributions to our understanding of the price discovery process in currency markets. First, it provides evidence that this process cannot be the familiar one based on adverse selection and customer spreads, since such spreads are inversely rel PRICE DISCOVERY IN CURRENCY MARKETSated to a trade's likely Information content. Second, the paper suggests three potential sources for the pattern of customer spreads, two of which relPRICE DISCOVERY IN CURRENCY MARKETS
y on the information structure of the market. Third, the paper suggests an alternative price discovery process for currencies, centered on inventory mPrice Discovery in Currency MarketsCarol L. Osler. Brandeis University. USA* Alexander Mende, University of Hannover. Germany Lukas Menkhoff, Universi PRICE DISCOVERY IN CURRENCY MARKETSeign exchange, asymmetric information, microstructure, price discovery, interdealer, inventory, market order, limit order]38961Corresponding author Carol Osler, cosler@brandeis.edu or Brandeis International Business School. Brandeis University, Mailstop 32, Waltham, MA 02454, USA. Tel. (781) 736-482 PRICE DISCOVERY IN CURRENCY MARKETS6. Fax (781) 736-2269. We are deeply grateful to the bankers who provided the data and to William Clyde, Pete Eggleston, Keith Henthorn, Valerie KrausPRICE DISCOVERY IN CURRENCY MARKETS
s. Peter Nielsen. Peter Tordo. and other bankers who discussed dealing with US. We thank, without implicating. Alain Chaboud. Yin-Wong Cheung. Joel HaPrice Discovery in Currency MarketsCarol L. Osler. Brandeis University. USA* Alexander Mende, University of Hannover. Germany Lukas Menkhoff, Universi PRICE DISCOVERY IN CURRENCY MARKETS Erik Theissen, and Dan Weaver for insightful comments.https://khothuvien.cori!Price Discovery in Currency MarketsThis paper investigates the price discovery process in the foreign exchange market. Understanding exactly how information becomes embedded in exchange rates is central to current efforts PRICE DISCOVERY IN CURRENCY MARKETS to understand exchange-rate dynamics (see. for example. Evans and Lyons (2002), (2004)). Within microstructure per se there is also a powerful incentPRICE DISCOVERY IN CURRENCY MARKETS
ive to study foreign exchange trading, since the currency market dwarfs all others. Nonetheless, the overall contours of price discovery in foreign exPrice Discovery in Currency MarketsCarol L. Osler. Brandeis University. USA* Alexander Mende, University of Hannover. Germany Lukas Menkhoff, Universi PRICE DISCOVERY IN CURRENCY MARKETS to the London Stock Exchange and some bond markets. In one. dealers trade with each other: in the other, dealers trade with (non-dealer) customers. The paper first provides evidence that spreads in the customer market are inversely related to a trade’s likely information content, which implies that PRICE DISCOVERY IN CURRENCY MARKETS price discover)' in FX cannot be determined by adverse selection. Second, the paper suggests three potential sources for this pattern of customer sprPRICE DISCOVERY IN CURRENCY MARKETS
eads, two of which are based on the information structure of the market. Finally, the paper proposes a price discovery process centered on dealers' inPrice Discovery in Currency MarketsCarol L. Osler. Brandeis University. USA* Alexander Mende, University of Hannover. Germany Lukas Menkhoff, Universi PRICE DISCOVERY IN CURRENCY MARKETS's two-tiered structure it has the potential to be relevant in liquid two-tiered markets for other assets.The adverse-selection-based price discover)' process, articulated in Glosten and Milgrom (1985) and Easley and O'Hara (1987). among other important works, asserts that dealers build into their p PRICE DISCOVERY IN CURRENCY MARKETSrice quotes the potential information revealed by a given customer transaction. When adverse selection dominates price discovery, spreads rise with thPRICE DISCOVERY IN CURRENCY MARKETS
e likelihood that a given customer has private information. Theoretical research indicates that under adverse selection larger trades are more likely Price Discovery in Currency MarketsCarol L. Osler. Brandeis University. USA* Alexander Mende, University of Hannover. Germany Lukas Menkhoff, Universi PRICE DISCOVERY IN CURRENCY MARKETS size. Adverse selection also implies wider spreads for informed customers if dealing is not anonymous.1Though the original adverse-selection models were inspired by equity markets, adverse selection has been assumed Io dominate price discovery in FX since Lyons (1995), which shows that trade size a PRICE DISCOVERY IN CURRENCY MARKETSnd spreads were positively related for a particular interbank dealer during a week in 1992. Most subsequent research has instead cone hided that interPRICE DISCOVERY IN CURRENCY MARKETS
bank c urrency spreads bear little or no relation to trade size (e.g., Yao (1998), Bjonnes and Rime (2005)). Nonetheless, Bjpnnes and Rime (2005) suggPrice Discovery in Currency MarketsCarol L. Osler. Brandeis University. USA* Alexander Mende, University of Hannover. Germany Lukas Menkhoff, Universi PRICE DISCOVERY IN CURRENCY MARKETSy the direction ol a trade that carries information, and presents evidenc e consistent with this alternative hypothesis.Most FX microstructure papers continue Io draw on adverse selection as their primary interpretive framework. Marsh and O'Rourke (2005), for example, estimates Easley, Kiefer, and O PRICE DISCOVERY IN CURRENCY MARKETS'Hara's (1996. 1997) adverse-selection-based measure of private information on daily FX customer data. Similarly. Payne (2003) estimates a VAR decompoPRICE DISCOVERY IN CURRENCY MARKETS
sition of interdealer trades and quotes and interprets the results, following Hasbrouck (1991). through the lense of adverse selection. Indeed, in thiPrice Discovery in Currency MarketsCarol L. Osler. Brandeis University. USA* Alexander Mende, University of Hannover. Germany Lukas Menkhoff, Universi PRICE DISCOVERY IN CURRENCY MARKETSlied by adverse selection.Our evidence indicates that adverse selection may have limited practical relevance in the customer tier of the FX market. We show that customer spreads are widest for the trades least likely to cany information. More specifically, customer spreads are inversely related to t PRICE DISCOVERY IN CURRENCY MARKETSrade size, and are narrower for the customers that dealers consider most informed, lhese reportedly informed customers arc financial firms, meaning asPRICE DISCOVERY IN CURRENCY MARKETS
set managers such as hedge funds or mutual funds: the other broad category of customers is commercial customcis, meaning firms that import or export.1Price Discovery in Currency MarketsCarol L. Osler. Brandeis University. USA* Alexander Mende, University of Hannover. Germany Lukas Menkhoff, Universi PRICE DISCOVERY IN CURRENCY MARKETS equivalently ticks) on laige financial trades to 13 pips on small commercial trades. (A pip is one unit of the smallest significant digit in an exchange rate as conventionally quoted. In the etiro-dollar market, where the exchange rale averaged $ 1.112R‘f. (hiring our sample period; a one-pip chang PRICE DISCOVERY IN CURRENCY MARKETSe from2that level would bring the rate to $1.1122/C. In this market one pip Is approximately one basis point, since the exchange rate is near unity.)IPRICE DISCOVERY IN CURRENCY MARKETS
f adverse selection doesn’t drive customer spreads in FX, what does? The paper's second contribution is to outline three alternative hypotheses, all oPrice Discovery in Currency MarketsCarol L. Osler. Brandeis University. USA* Alexander Mende, University of Hannover. Germany Lukas Menkhoff, Universi PRICE DISCOVERY IN CURRENCY MARKETSs (2003)): adverse selection, inventory risk, operating costs, and (occasionally) monopoly power. Researchers in currency microstructure generally assume the tripartite division (e.g.. Rime (2003)), since intense competition among the hundreds of FX dealers rules out pure monopoly power. The three r PRICE DISCOVERY IN CURRENCY MARKETSemaining components cannot fully explain the pattern of currency spreads, however. Adverse selection predicts the opposite pattern for both size- andPRICE DISCOVERY IN CURRENCY MARKETS
customer-based variation, as noted above. Inventor}’ risk also predicts the opposite size-based variation and it predicts zero customer-based variatioPrice Discovery in Currency MarketsCarol L. Osler. Brandeis University. USA* Alexander Mende, University of Hannover. Germany Lukas Menkhoff, Universi PRICE DISCOVERY IN CURRENCY MARKETSand customer spreads if some costs are fixed.To explain why FX spreads are larger for commercial than financial customers we suggest that asymmetric information - in the broad sense of information that is held by some but not all market participants - may influence spreads through two channels disti PRICE DISCOVERY IN CURRENCY MARKETSnct from adverse selection. The first channel involves market power. As suggested in Green et al. (2004), dealers may quote the widest spreads when thPRICE DISCOVERY IN CURRENCY MARKETS
eir market power is greatest, and market power in quote-driven markets depends on knowledge of current market conditions. In FX, commercial customers Price Discovery in Currency MarketsCarol L. Osler. Brandeis University. USA* Alexander Mende, University of Hannover. Germany Lukas Menkhoff, Universi PRICE DISCOVERY IN CURRENCY MARKETS through which asymmetric information might affect customer spreads in FX involves strategic dealing. Building on abundant evidence that customer order flow carries information (e.g., Evans and Lyons (2004), Danielsson Ct al. (2002)), we argue that rational FX dealers might strategically vary spread PRICE DISCOVERY IN CURRENCY MARKETSs across customers to gain information which they can then exploit in upcoming interbank trades. In standard adverse-selection models, by contrast, dePRICE DISCOVERY IN CURRENCY MARKETS
alers passively accept the information content of order flow. We suggest that FX dealers effectively subsidize spreads on the3customer transactions moGọi ngay
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