Price Formation in the Foreign Exchange Market

We study joint price formation in the dealer-to-dealer (D2D) and dealer-to-customer (D2C) segments of the foreign exchange (FX) market, both theoretically and empirically. Our theory accounts for dealer heterogeneity, market power, and non-exclusive customer-dealer relationship and shows that several statistics of the cross-section of D2C quotes help predict D2D prices and liquidity. In particular, D2D prices are negatively related to cross-sectional covariance between D2C mid-quotes and spreads, contrary to predictions of other theories of two-tiered markets. Our predictions are confirmed empirically using unique proprietary D2C data. Model calibration reveals and quantifies the FX market’s inelasticity and non-competitiveness.

Keywords: Liquidity, Foreign Exchange, OTC markets, Price Impact, Market Power

JEL Classification: F31, G12, G14, G21

Suggested Citation: Suggested Citation

Gallien, Florent and Glebkin, Sergei and Kassibrakis, Serge and Malamud, Semyon and Teguia, Alberto, Price Formation in the Foreign Exchange Market (August 28, 2023). Swiss Finance Institute Research Paper No. 23-68, INSEAD Working Paper No. 2023/63/FIN, Available at SSRN: https://ssrn.com/abstract=4554523 or http://dx.doi.org/10.2139/ssrn.4554523