FOREX Microstructure, Invisible Price Determinants,and the Central Bank's Understanding of Exchange Rate Formation
AbstractThe paper investigates the transmission of macroeconomic factors into the price-setting behavior of a specific dealer in the FX market. This problem is viewed from the perspective of a central banker who observes the price evolution but does not make the market in the home currency. The central banker's task is to explain the forex behavior in terms of conventional economic logic. The analysis is based on a model of a multiple dealer market under two organizations - direct inter-dealer and brokered. The model is constructed in such a way as to reflect the most prominent features of the market for the Czech koruna and, accordingly, to address some issues of key relevance to the Czech National Bank's exchange rate policy. We show that the totality of the exchange rate-relevant fundamental factors influence the market maker's behavior through a single sufficient statistic, his 'marginal' valuation of foreign currency holdings. Under the two studied trading mechanisms, the marginal valuations across market participants determine the equilibrium exchange rate by means of different trade patterns. Specifically, the brokered market is inferior to the direct one in terms of welfare improvement through trade. It takes a higher inter-dealer trade volume in the brokered market to absorb a new price impulse. Therefore, the central banker would do best by monitoring the brokered segment (as the only partially transparent one available), but by conducting interventions in the direct segment, where the desired impact is easier to achieve.
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Bibliographic InfoPaper provided by Czech National Bank, Research Department in its series Working Papers with number 2003/06.
Date of creation: Jun 2003
Date of revision:
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More information through EDIRC
forex microstructure; multiple dealership; order flow; pricing schedule.;
Find related papers by JEL classification:
- F31 - International Economics - - International Finance - - - Foreign Exchange
- G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
- C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
This paper has been announced in the following NEP Reports:
- NEP-ALL-2005-04-17 (All new papers)
- NEP-FIN-2005-04-16 (Finance)
- NEP-IFN-2005-04-22 (International Finance)
- NEP-TRA-2005-04-18 (Transition Economics)
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