Theoretical perspective on euro liquidity

The distribution of realized exchange rate volatility

Richard K. Lyons

Economic Policy, 2002, vol. 17, issue 35, 571-597

Abstract: Forex markets and the euroTheoretical prespectiveI provide theoretical perspective on recent findings of increased transaction costs in the new dollar-euro market relative to the prior dollar-mark market, and assess the welfare significance of this drop in liquidity. In theory, transaction costs arise from information disadvantage costs, inventory management costs, and other market-making costs (e.g., order-processing costs). A review of theoretical reasons for the underlying costs to be rising can allow one to discriminate among hypotheses for the liquidity drop. New data on public trades support a customer liquidity hypothesis, based on the idea that the ultimate providers of liquidity in this market are customers rather than market-makers. However, the hypothesis is not consistent with the totality of the evidence, and I discuss how a combination of various mechanisms can influence transaction costs and the FX market's information efficiency.–Richard K. Lyons

Date: 2002
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