New Economics Papers
on Market Microstructure
Issue of 2012‒10‒06
three papers chosen by
Thanos Verousis

  1. The Microstructure of Currency Markets By Carol Osler; Xuhang Wang
  2. Market Microstructure and the Profitability of Currency Trading By Carol Osler
  3. Financial Intermediation and the Role of Price Discrimination in a Two-Tier Market By Stefan Reitz; Markus A. Schmidt; Mark P. Taylor

  1. By: Carol Osler (International Business School, Brandeis University); Xuhang Wang (Graduate student, Brandeis University)
    Abstract: This paper describes the structure and microeconomics of the foreign exchange market. It begins by outlining the major participants and the instruments they trade, highlighting the vast institutional changes that accompanied the emergence of electronic trading since the 1990s. It then discusses how and why order flow drives exchange rates; the economics of liquidity provision; the price discovery process; and volatility.
    Date: 2012–09
  2. By: Carol Osler (International Business School, Brandeis University)
    Abstract: Currency trading is a vast and highly profitable business. This paper examines the profitability of two popular currency trading strategies in light of currency-market microstructure research. The carry-trade strategy involves borrowing a low-interest currency and investing the proceeds in a high-interest currency. Technical trading strategies are determined exclusively on the basis of past asset prices and trading volumes. Under the efficient markets hypothesis, neither of these approaches to speculative trading should produce excess returns. The review shows that the profitability of carry-trade investing and technical trading strategies can represent rational long-run equilibria given the structure of currency markets and the incentives and constraints faced by traders.
    Keywords: Carry trade, Technical analysis, Skewness, Liquidity
    JEL: F31
    Date: 2012–09
  3. By: Stefan Reitz; Markus A. Schmidt; Mark P. Taylor
    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
    Keywords: Foreign Exchange, Market Mictrostructure, Pricing Behavior
    JEL: F31 F41
    Date: 2012–09

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