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Liquidity Provision in the Foreign Exchange Market

Author

Listed:
  • Florent Gallien

    (Swissquote Bank)

  • Serge Kassibrakis

    (Swissquote Bank)

  • Nataliya Klimenko

    (University of Zurich)

  • Semyon Malamud

    (Ecole Polytechnique Federale de Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute)

  • Alberto Teguia

    (Rice University)

Abstract

Foreign exchange operates as a two-tiered over-the-counter (OTC) market dominated by large, strategic dealers. Using proprietary high frequency data on quotes by the largest foreign exchange dealer banks in the Dealer-to-Client market, we nd a signi cant heterogeneity in their behavior. We develop a model of strategic competition that accounts for this heterogeneity and the two-tier market structure and allows us to link prices and bid-ask spreads in the D2C and D2D market segments. We use the model to recover dealers' risk aversions and inventories from their quotes in the D2C segment and construct an endogenous measure of systemic, non-diversi able risk capturing the cross-sectional liquidity-risk mismatch. Consistent with the model predictions, we nd that liquidity mismatch negatively predicts prices in the D2D market, while the cross-sectional dispersion in dealer risk aversions negatively predicts spreads in the D2D market.

Suggested Citation

  • Florent Gallien & Serge Kassibrakis & Nataliya Klimenko & Semyon Malamud & Alberto Teguia, 2018. "Liquidity Provision in the Foreign Exchange Market," Swiss Finance Institute Research Paper Series 18-56, Swiss Finance Institute, revised Aug 2018.
    • Handle: RePEc:chf:rpseri:rp1856
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    Cited by:

    1. Jean-Edouard Colliard & Thierry Foucault & Peter Hoffmann, 2018. "Inventory Management, Dealers' Connections, and Prices in OTC Markets," Working Papers hal-01933855, HAL.

    More about this item

    Keywords

    Liquidity; Foreign Exchange; OTC markets; Price Impact; Market Power;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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