Dealer Heterogeneity and Exchange Rates
155 Pages Posted: 22 Aug 2018 Last revised: 11 Feb 2023
Date Written: July 15, 2018
We show, both theoretically and empirically, that several statistics of dealer heterogeneity affect prices and liquidity in the foreign exchange (FX) market. A higher cross-sectional covariance between dealers’ risk aversions and inventories is associated with higher FX returns. Although unobservable, this statistic can be proxied by the cross-sectional covariance between dealer-to-customer (D2C) prices and bid-ask spreads. A higher cross sectional dispersion of dealer risk aversions is associated with higher liquidity in the dealer to-dealer market and can be proxied by the crosssectional dispersion of D2C spreads. These predictions are confirmed empirically using proprietary data on the largest FX dealers’ D2C quotes.
Keywords: Liquidity, Foreign Exchange, OTC markets, Price Impact, Market Power
JEL Classification: F31, G12, G14, G21
Suggested Citation: Suggested Citation