Price Discovery in Currency Markets
51 Pages Posted: 15 Mar 2006
Date Written: March 2007
This paper makes three contributions to our understanding of the price discovery process in currency markets. First, it provides evidence that this process cannot be the familiar one based on adverse selection and customer spreads, since such spreads are inversely related to a trade's likely information content. Sec-ond, the paper suggests three potential sources for the pattern of customer spreads, two of which rely on the information structure of the market. Third, the paper suggests an alternative price discovery process for currencies, centered on inventory management strategies in the interdealer market, and provides preliminary evidence for that process. We suggest more broadly that the price discovery process will vary with market structure, and that our proposed mechanism may apply to liquid two-tier markets in general.
Keywords: Bid-ask spreads, foreign exchange, asymmetric information, microstructure, price discovery, interdealer, inventory, market order, limit order
JEL Classification: F31, G14, G15
Suggested Citation: Suggested Citation