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An Intraday Pricing Model of Foreign Exchange Markets

  • Rafael Romeu
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    Market makers learn about asset values as they set intraday prices and absorb portfolio flows. Absorbing these flows causes inventory imbalances. Previous work has argued that market makers change prices to manage incoming flows and offset inventory imbalances. This study argues that they have multiple instruments, or ways to manage inventory imbalances and learn about evolving asset values. Hence, they smooth inventory levels and update prior information about assets using multiple instruments. In ignoring other instruments, previous studies have ignored the information that these provide and overemphasize the role of price changes in inventory management. The model presented here provides new estimates of asymmetric information and inventory effects, the price impact of each instrument, the cost of liquidity, and the impact of an intervention on these costs.

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    Paper provided by International Monetary Fund in its series IMF Working Papers with number 03/115.

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    Length: 35
    Date of creation: 01 Jun 2003
    Date of revision:
    Handle: RePEc:imf:imfwpa:03/115
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    1. Martin D.D. Evans, H. Henry Cao, Richard K. Lyons, 2003. "Inventory Information," Working Papers gueconwpa~03-03-33, Georgetown University, Department of Economics.
    2. Kenneth A. Froot & Tarun Ramadorai, 2001. "The Information Content of International Portfolio Flows," NBER Working Papers 8472, National Bureau of Economic Research, Inc.
    3. Ananth Madhavan & Seymour Smidt, . "A Bayesian Model of Intraday Specialist Pricing," Rodney L. White Center for Financial Research Working Papers 2-91, Wharton School Rodney L. White Center for Financial Research.
    4. Takatoshi Ito Richard K. Lyons and Michael T. Melvin., 1997. "Is There Private Information in the FX Market? The Tokyo Experiment," Research Program in Finance Working Papers RPF-270, University of California at Berkeley.
    5. O'Hara, Maureen & Oldfield, George S., 1986. "The Microeconomics of Market Making," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 21(04), pages 361-376, December.
    6. Rime,D., 2000. "Private or public information in foreign exchange markets? : an empirical analysis," Memorandum 14/2000, Oslo University, Department of Economics.
    7. Evans, Martin D. & Lyons, Richard K., 1999. "Order Flow and Exchange Rate Dynamics," Research Program in Finance, Working Paper Series qt0dh1c16w, Research Program in Finance, Institute for Business and Economic Research, UC Berkeley.
    8. Easley, David & O'Hara, Maureen, 1987. "Price, trade size, and information in securities markets," Journal of Financial Economics, Elsevier, vol. 19(1), pages 69-90, September.
    9. Hasbrouck, Joel, 1988. "Trades, quotes, inventories, and information," Journal of Financial Economics, Elsevier, vol. 22(2), pages 229-252, December.
    10. Richard K. Lyons, 1993. "Tests of Microstructural Hypotheses in the Foreign Exchange Market," NBER Working Papers 4471, National Bureau of Economic Research, Inc.
    11. Froot, Kenneth A. & O'Connell, Paul G. J. & Seasholes, Mark S., 2001. "The portfolio flows of international investors," Journal of Financial Economics, Elsevier, vol. 59(2), pages 151-193, February.
    12. Thomas Ho & Hans Stoll, . "Optimal Dealer Pricing Under Transactions and Return Uncertainty," Rodney L. White Center for Financial Research Working Papers 27-79, Wharton School Rodney L. White Center for Financial Research.
    13. Flood, Robert P & Rose, Andrew K, 1993. "Fixing Exchange Rates: A Virtual Quest for Fundamentals," CEPR Discussion Papers 838, C.E.P.R. Discussion Papers.
    14. Dominguez, Kathryn M & Frankel, Jeffrey A, 1993. "Does Foreign-Exchange Intervention Matter? The Portfolio Effect," American Economic Review, American Economic Association, vol. 83(5), pages 1356-69, December.
    15. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
    16. Frankel, Jeffrey A. & Rose, Andrew K., 1995. "Empirical research on nominal exchange rates," Handbook of International Economics, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 33, pages 1689-1729 Elsevier.
    17. Hans R. Stoll, . "The Supply of Dealer Services in Securities Markets," Rodney L. White Center for Financial Research Working Papers 02-78, Wharton School Rodney L. White Center for Financial Research.
    18. Jushan Bai & Pierre Perron, 1998. "Estimating and Testing Linear Models with Multiple Structural Changes," Econometrica, Econometric Society, vol. 66(1), pages 47-78, January.
    19. Robert P. Flood & Mark P. Taylor, 1996. "Exchange Rate Economics: What's Wrong with the Conventional Macro Approach?," NBER Chapters, in: The Microstructure of Foreign Exchange Markets, pages 261-302 National Bureau of Economic Research, Inc.
    20. Madhavan, Ananth & Sofianos, George, 1998. "An empirical analysis of NYSE specialist trading," Journal of Financial Economics, Elsevier, vol. 48(2), pages 189-210, May.
    21. Manaster, Steven & Mann, Steven C, 1996. "Life in the Pits: Competitive Market Making and Inventory Control," Review of Financial Studies, Society for Financial Studies, vol. 9(3), pages 953-75.
    22. Anat R. Admati, Paul Pfleiderer, 1988. "A Theory of Intraday Patterns: Volume and Price Variability," Review of Financial Studies, Society for Financial Studies, vol. 1(1), pages 3-40.
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