Price Discovery in Currency Markets

51 Pages Posted: 15 Mar 2006

See all articles by Carol L. Osler

Carol L. Osler

Brandeis University - International Business School

Lukas Menkhoff

German Institute for Economic Research (DIW Berlin); Humboldt University of Berlin - Faculty of Economics

Alexander Mende

University of Hannover

Date Written: March 2007

Abstract

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

Osler, Carol L. and Menkhoff, Lukas and Mende, Alexander, Price Discovery in Currency Markets (March 2007). EFA 2006 Zurich Meetings. Available at SSRN: https://ssrn.com/abstract=890774 or http://dx.doi.org/10.2139/ssrn.890774

Carol L. Osler (Contact Author)

Brandeis University - International Business School ( email )

Mailstop 32
Waltham, MA 02454-9110
United States
781-736-4826 (Phone)

Lukas Menkhoff

German Institute for Economic Research (DIW Berlin) ( email )

Mohrenstra├če 58
Berlin, 10117
Germany

Humboldt University of Berlin - Faculty of Economics ( email )

Spandauer Strasse 1
Berlin
Germany

Alexander Mende

University of Hannover ( email )

Welfengarten 1
D-30167 Hannover, 30167
Germany

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