An Intraday Pricing Model of Foreign Exchange Markets
IMF Working Papers, June 1, 2003
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- An Intraday Pricing Model of Foreign Exchange Markets
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Bibliographic details
- Authors: Rafael Romeu
- Published: June 1, 2003
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451853889.001
Summary
- Market makers learn about asset values as they set intraday prices and absorb portfolio flows.
- Absorbing these flows causes inventory imbalances.
- Previous work argues market makers change prices to manage incoming flows and offset inventory imbalances.
- This study argues market makers have multiple instruments to manage inventory imbalances and learn about evolving asset values.
- Market makers smooth inventory levels and update prior information about assets using multiple instruments.
- By ignoring other instruments, previous studies have:
- ignored the information these instruments provide, and
- overemphasized the role of price changes in inventory management.
- The model presented 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.
Key findings and estimates
- The paper provides new estimates of asymmetric information effects.
- The paper provides new estimates of inventory effects.
- The paper quantifies the price impact of each instrument used by market makers.
- The paper quantifies the cost of liquidity.
- The paper quantifies the impact of an intervention on liquidity costs.
Policy relevance and implications
- Understanding multiple instruments used by market makers alters assessment of how prices respond to order flow.
- Recognizing additional instruments changes estimates of information content in traded prices and the measured cost of liquidity.
- Evaluations of interventions should account for their impact on multiple instruments and resulting liquidity costs.