Tests of Microstructural Hypotheses in the Foreign Exchange Market

Abstract

This paper introduces a transactions dataset to test microstructural hypotheses in the spot foreign exchange market. The dataset reflects all the trading activity of a dealer whose average daily volume is over $1 billion over the five-day sample. We use the data to test for effects of trading volume on prices through the two channels stressed in the literature: the information channel and the inventory-control channel. We find that trades have both a strong information effect and a strong inventory-control effect, providing support for both branches of microstructure theory. The strong inventory-control effect arises despite the fact that foreign exchange dealers have an additional means of inventory control that a specialist does not, namely trading on another dealer's prices.

JEL Classification: G15