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Price discovery in currency markets

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  • Osler, Carol L.
  • Mende, Alexander
  • Menkhoff, Lukas

Abstract

This paper examines the price discovery process in currency markets, basing its analysis on the pivotal distinction between the customer (end-user) market and the interdealer market. It first provides evidence that this price discovery process cannot be based on adverse selection between dealers and their customers, as postulated in standard models, because the spreads dealers quote to their customers are not positively related to a trade’s likely information content. The paper then highlights three factors familiar in the literature – fixed operating costs, market power, and strategic dealing – that may explain the cross-sectional variation in customers’ spreads. The paper finishes by proposing a price discovery process relevant to liquid two-tier markets and providing preliminary evidence that this process applies to currencies.

Suggested Citation

  • Osler, Carol L. & Mende, Alexander & Menkhoff, Lukas, 2011. "Price discovery in currency markets," Journal of International Money and Finance, Elsevier, vol. 30(8), pages 1696-1718.
  • Handle: RePEc:eee:jimfin:v:30:y:2011:i:8:p:1696-1718
    DOI: 10.1016/j.jimonfin.2011.08.004
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    More about this item

    Keywords

    Exchange rates; Foreign exchange microstructure; Asymmetric information; Bid-ask spreads; Price discovery;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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