Structural Interdependence of Price and Demand in a Model of the Foreign Exchange Market with Heterogeneous Speculators: Evidence from High-frequency Data

Abstract

We assume that the variations of the exchange rate depend on the current net demand of the base currency as a consequence of market making, and that the current net demand of the base currency depends on current and past variations of the exchange rate as a consequence of how future price expectations are formed by bounded rational agents. We achieve identification supposing that the structural shocks of price variations and demand follow a GARCH process. Using high-frequency transaction data of the EUR/USD market in 2016, we show that the simultaneous effects of price on demand and vice-versa are both significant and positive. Our estimates suggest that one important source of heterogeneity in demand might be missing from our model, since the structural errors are negatively correlated.

Keywords: Heterogeneous beliefs, market making, foreign exchange market, SVAR-GARCH, high frequency data

JEL Classification: G12, D84, F31, C32, C55