Continuous Time Decision-Making in a Partially Decentralized Multiple Dealership Forex Market, and the Equilibrium Exchange Rate

28 Pages Posted: 4 Apr 2001

See all articles by Alexis Derviz

Alexis Derviz

Czech National Bank (CNB) - Monetary Department

Abstract

The paper introduces a model of bid/ask price formation in an imperfectly centralized forex dealership market in continuous time. The dealers have costly access to best quotes. They interpret signals from the joint dealer-customer order flow and decide upon their own quotes and trades in the inter-dealer market. The lowest ask/highest bid price of a foreign currency becomes the single transaction price in equilibrium. Each dealer uses the observed order flow to improve the subjective estimates of relevant aggregate variables, which are the sources of uncertainty. These are: returns on domestic and foreign assets, the equilibrium FX transaction price and the size of the aggregate dealer transactions in the FX market. These uncertainties have diffusion form and are dealt with according to principles of portfolio optimization in continuous time. The price information content of the local order flow observed by the dealer, has to do with the existence of ifgloballo investors in the dealer's customer base. Global investors have access to bid-ask quotes of more than one dealer, along with superior information about fundamentals. These two factors help them generate better estimates of the future inter-dealer transactions than both the ihlocalli investors (i.e. those who only trade with their single local dealer) and any of the dealers themselves. I obtain the formula for the dealer spread around the equilibrium price. I also show how informational customer-dealer asymmetries generate non-stationary cumulative order flows as well as deviations of the inter- dealer transaction price from uncovered parity of national asset returns.

Keywords: Optimizing dealer, forex microstructure, diffusion uncertainty, inter-dealer market

JEL Classification: F31, G11, G29, D49, D82

Suggested Citation

Derviz, Alexis, Continuous Time Decision-Making in a Partially Decentralized Multiple Dealership Forex Market, and the Equilibrium Exchange Rate. Available at SSRN: https://ssrn.com/abstract=264588 or http://dx.doi.org/10.2139/ssrn.264588

Alexis Derviz (Contact Author)

Czech National Bank (CNB) - Monetary Department ( email )

Na Prikope 28
CZ-11503 Praha 1
Czech Republic

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
349
Abstract Views
2,739
rank
100,443
PlumX Metrics