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Components of the Czech Koruna Risk Premium in a Multiple-Dealer FX Market

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  • Alexis Derviz

Abstract

The paper proposes a continuous time model of an FX market organized as a multiple dealership. The model reflects a number of salient features of the Czech koruna spot market. The dealers have costly access to the best available quotes. They interpret signals from the joint dealer-customer order flow and decide upon their own quotes and trades in the inter-dealer market. Each dealer uses the observed order flow to improve the subjective estimates of the relevant aggregate variables, which are the sources of uncertainty. One of the risk factors is the size of the cross-border dealer transactions in the FX market. These uncertainties have diffusion form and are dealt with according to the principles of portfolio optimization in continuous time. The model is used to explain the country, or risk, premium in the uncovered national return parity equation for the koruna/euro exchange rate. The two country premium terms that I identify in excess of the usual covariance term (a consequence of the 'Jensen inequality effect') are the dealer heterogeneity-induced inter-dealer market order flow component and the dealer Bayesian learning component. As a result, a 'dealer-based total return parity' formula links the exchange rate to both the 'fundamental' factors represented by the differential of the national asset returns, and the microstructural factors represented by heterogeneous dealer knowledge of the aggregate order flow and the fundamentals. Evidence on the cross-border order flow dependence of the Czech koruna risk premium, in accordance with the model prediction, is documented.

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Bibliographic Info

Paper provided by Czech National Bank, Research Department in its series Working Papers with number 2003/04.

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Date of creation: Jun 2003
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Handle: RePEc:cnb:wpaper:2003/04

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Keywords: Bayesian learning; FX microstructure; optimizing dealer; uncovered parity.;

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References

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  1. Martin D. D. Evans and Richard K. Lyons., 1999. "Order Flow and Exchange Rate Dynamics," Research Program in Finance Working Papers RPF-288, University of California at Berkeley.
  2. Dan Bernhardt & Eric Hughson, 1993. "Splitting Orders," Working Papers 888, Queen's University, Department of Economics.
  3. Kerry Back & C. Henry Cao & Gregory A. Willard, 2000. "Imperfect Competition among Informed Traders," Journal of Finance, American Finance Association, vol. 55(5), pages 2117-2155, October.
  4. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, vol. 14(1), pages 71-100, March.
  5. William Perraudin & Paolo Vitale, 1996. "Interdealer Trade and Information Flows in a Decentralized Foreign Exchange Market," NBER Chapters, in: The Microstructure of Foreign Exchange Markets, pages 73-106 National Bureau of Economic Research, Inc.
  6. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
  7. Michael J. Brennan. and H. Henry Cao., 1997. "International Portfolio Investment Flows," Research Program in Finance Working Papers RPF-271, University of California at Berkeley.
  8. Francisco Nadal-De Simone & Weshah Razzak, 1999. "Nominal Exchange Rates and Nominal Interest Rate Differentials," IMF Working Papers 99/141, International Monetary Fund.
  9. Glosten, Lawrence R, 1989. "Insider Trading, Liquidity, and the Role of the Monopolist Specialist," The Journal of Business, University of Chicago Press, vol. 62(2), pages 211-35, April.
  10. Madhavan, Ananth & Smidt, Seymour, 1993. " An Analysis of Changes in Specialist Inventories and Quotations," Journal of Finance, American Finance Association, vol. 48(5), pages 1595-1628, December.
  11. Back, Kerry & Pedersen, Hal, 1998. "Long-lived information and intraday patterns," Journal of Financial Markets, Elsevier, vol. 1(3-4), pages 385-402, September.
  12. Zapatero, Fernando, 1998. "Effects of financial innovations on market volatility when beliefs are heterogeneous," Journal of Economic Dynamics and Control, Elsevier, vol. 22(4), pages 597-626, April.
  13. Back, Kerry, 1992. "Insider Trading in Continuous Time," Review of Financial Studies, Society for Financial Studies, vol. 5(3), pages 387-409.
  14. Detemple, Jerome B, 1986. " Asset Pricing in a Production Economy with Incomplete Information," Journal of Finance, American Finance Association, vol. 41(2), pages 383-91, June.
  15. Alexis Derviz, 2002. "The uncovered parity properties of the czech koruna," Prague Economic Papers, University of Economics, Prague, vol. 2002(1).
  16. Ho, Thomas S Y & Stoll, Hans R, 1983. " The Dynamics of Dealer Markets under Competition," Journal of Finance, American Finance Association, vol. 38(4), pages 1053-74, September.
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Cited by:
  1. Holub, Tomáš, 2004. "Foreign exchange interventions under inflation targeting: the Czech Experience," Research Notes 17, Deutsche Bank Research.
  2. Alexis Derviz, 2004. "Exchange rate risks and asset prices in a small open economy," Working Paper Series 314, European Central Bank.
  3. Ales Bulir, 2004. "Liberalized Markets Have More Stable Exchange Rates: Short-Run Evidence from Four Transition Countries," IMF Working Papers 04/35, International Monetary Fund.
  4. Tomas Holub, 2005. "Forex interventions: the Czech experience," BIS Papers chapters, in: Bank for International Settlements (ed.), Foreign exchange market intervention in emerging markets: motives, techniques and implications, volume 24, pages 150-61 Bank for International Settlements.
  5. Ales Bulir, 2003. "Some Exchange Rates Are More Stable than Others: Short-Run Evidence from Transition Countries," Working Papers 2003/05, Czech National Bank, Research Department.

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