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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.

Suggested Citation

  • Alexis Derviz, 2003. "Components of the Czech Koruna Risk Premium in a Multiple-Dealer FX Market," Working Papers 2003/04, Czech National Bank, Research and Statistics Department.
    • Handle: RePEc:cnb:wpaper:2003/04
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    File URL: https://www.cnb.cz/export/sites/cnb/en/economic-research/.galleries/research_publications/cnb_wp/wp4-2003.pdf
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    References listed on IDEAS

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    Cited by:

    1. Adam Geršl & Tomáš Holub, 2006. "Foreign Exchange Interventions Under Inflation Targeting: The Czech Experience," Contemporary Economic Policy, Western Economic Association International, vol. 24(4), pages 475-491, October.
    2. 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.
    3. Derviz, Alexis, 2004. "Exchange rate risks and asset prices in a small open economy," Working Paper Series 314, European Central Bank.
    4. Aleš Bulíø, 2005. "Liberalized Markets Have More Stable Exchange Rates: Short-Run Evidence from Four Transition Countries," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 55(5-6), pages 206-231, May.
    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 and Statistics Department.

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    More about this item

    Keywords

    Bayesian learning; FX microstructure; optimizing dealer; uncovered parity;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G29 - Financial Economics - - Financial Institutions and Services - - - Other
    • D49 - Microeconomics - - Market Structure, Pricing, and Design - - - Other
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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