| Abstract: |
Though unambiguously outperforming all other financial markets in terms of
liquidity, foreign exchange trading is still performed in opaque and
decentralized markets. In particular, the two-tier market structure consisting
of a customer segment and an interdealer segment to which only market makers
have access gives rise to the possibility of price discrimination. We provide
a theoretical foreign exchange pricing model that accounts for market power
considerations and analyze a database of the trades of a German market maker
and his cross section of end-user customers. We find that the market maker
generally exerts low bargaining power vis-á-vis his customers. The dealer
earns lower average spreads on trades with financial customers than commercial
customers, even though the former are perceived to convey
exchange-rate-relevant information. From this perspective, it appears that
market makers provide interdealer market liquidity to end-user customers with
cross-sectionally differing spreads. |