FOREX Microstructure, Invisible Price Determinants,and the Central Bank's Understanding of Exchange Rate Formation

Alexis Derviz ()

Working Papers from Czech National Bank, Research and Statistics Department

Abstract: The 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.

Keywords: forex microstructure; multiple dealership; order flow; pricing schedule. (search for similar items in EconPapers)
JEL-codes: C72 F31 G15 (search for similar items in EconPapers)
Date: 2003-06
New Economics Papers: this item is included in nep-fin, nep-ifn and nep-tra
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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