Outline: 1. Description of Foreign Exchange Trading

Outline
1. Description of Foreign Exchange Trading

2. The Dealers Perspective
3. The Customers Perspective
1. Importers / Exporters
2. International Investors
4. The Policy Makers Perspective
Prof. Reitz FX Markets - Theory and Empirics 1

2. The Dealers Perspective___________________________________________________________
2. The Dealers Perspective

2.1 The Single Dealer Approach
2.2 Dealer Trading in Segmented Markets
2.3 The Multiple Dealer Approach
Literature:
Madhavan, A., and S. Smidt. 1991. A Bayesian model of intraday
specialist pricing. Journal of Financial Economics 30: 99134.
Reitz, S., Schmidt, M., and M.P. Taylor, 2011, End-User Order Flow
and Exchange Rate Dynamics, European Journal of Finance Vol. 17, 153 -168

Source: Deutsche Bundesbank, MB 1/2008

The Madhavan and Smidt 1991 model

Describes the pricing of a market maker in
asset markets.
We assume that the full information price of
the foreign currency is a stochastic variable
~
~ = di
i
di is the exchange rates innovation, so that the

full information price evolves as a martingale.
E [ pt +1 pt ] = pt
The underlying stochastic process is the same

as the standard asset market approach
Derived results are comparable
Due to real world disturbances, however,
prices deviate from the expected value,
because of
Transaction costs
Inventory effects
Asymmetric information

Transaction costs
We assume a fixed transaction cost
component per trade
Denote Dt as a trade direction indicator such
that
Dt = 1, if a customer buys foreign currency
Dt = -1, if a customer sells foreign currency.

Inventory effects
We assume the market maker dislikes
deviations of current inventory It from a desired
inventory level Id.
In case of excess inventory, she lowers prices
at a rate of (I t I d )
The coefficient measures the speed of
adjustment (urgency of adjustment).
Of course, may vary over a trading day.
(Why?)

Asymmetric information
Suppose the market maker is asked for quotes
by an international hedge fund
good for USD 100 mill.
What is the market makers problem?
The possibility of an important piece of
information in the hand of the customer should
be considered in the pricing schedule
The market maker tries to hedge the risk of
information disadvantage.

Under these circumstances the market

makers quotes are
pt = t (I t I d ) + Dt (1)
where t is the market makers expectation of

the true value of foreign currency t.
How does the market maker exploit available

information efficiently?

Information processing
Just before time t all agents observe a noisy
public information signal
yt = t + t where t ~ iid . N ( 0, 2
)
The customer additionally carries a private

signal
wt = t + t , and t ~ iid . N (0, 2 )

Bayesian learning leads to the customers
posterior expectation of the true value
2
mt = wt + (1 ) y t , where = 2 (2)
+ 2
Customers demand function linear in the

perceived mispricing
qt = (mt pt ) xt (3)

Liquidity shock xt is private information, but
across all customers it is assumed that
xt ~ iid . N (0, ) 2
x
Market maker is unable to disentangle the

sources of customers demand
Demand (order flow) is a noisy signal
But it helps to infer some of the private info

From (2) and (3) the market maker knows
qt = (wt + (1 ) y t pt ) xt
pt + qt (1 ) yt + xt
wt =

Remember that xt is zero across all customers
pt + qt (1 ) yt
E [wt qt ] = (4)


Combining this info with the public prior gives
s2
t = yt + (1 )E [wt qt ] where = 2 or
s + 2
qt
t = y t + (1 ) pt + , where = ( + 1) / (5)

The market makers posterior mean is a

weighted average of prior info and the signal
conveyed by order flow.
is the weight placed on prior beliefs!
Pricing schedule of the market maker

Substituting (5) into (1)
qt
pt = y t + (1 ) pt + (I t I d ) + Dt (6)

Standard asset market approach
pt = y t + Dt

Conclusions 1
Asymmetric information forces the market
maker to increase exchange rates when
customers buy foreign exchange and vice
versa.
By charging customers in the described
fashion the market maker is compensated for
her information disadvantage.
Asymmetric information opens the door for
order flow as an important driver of exchange
rates
Conclusions 2
There is no Walrasian auctioneer clearing the
market. Since the market makers always
agrees to trade she accumulates positions of
foreign currency Inventory considerations
In contrast to Rational Expectations models
orders precede prices changes!

Conclusions 3
A net market surplus of foreign currency
imposes a pressure on exchange rates via the
inventory component. Depending on market
clearing may take some time!
Transaction costs and asymmetric information
costs give rise to so-called bid/ask spreads.

Empirical Evidence
Eq. (6) cannot be estimated because the
market makers prior yt is unobservable.
The MS(1991) solution to the problem is to add
yt to either side of lagged (1) to get
y t + pt 1 = t 1 (I t 1 I d ) + Dt 1 + y t
y t = pt 1 + (I t 1 I d ) Dt 1 + y t t 1 (7)
The last term is a public information signal and

cannot be predicted ex ante.

Empirical Evidence
(7) in (6):

Pt = + qt I t + I t 1 + Dt Dt 1 + t (8)

The coefficient = (1-)/() captures the

information effect!
The coefficient = -(1-1/)Id
captures a trend in exchange rates due to a
desired inventory level. We suspect that
Id = 0! Why?
Data set
Tick-by-tick data from a German bank
Data from Oct. 1st, 2002 to Sept. 30th, 2003
(254 trading days, 11,830 transactions)
Trade records contain
currency pair
date and time of trade
trade direction
deal size and transaction price
counterparty type and trade initiator
Source: Reitz et al. (2010)

Data set
Table 1
Trading activity of a small German bank
254 trading days between October 1st , 2002 and September 30th, 2003
Financial Commercial Internal Interbank All Transactions
Customers Customers Customers
Incoming transactions 189 5,229 639 5,773 11,830
Percent 1.6% 44.2% 5.4% 48.8% 100.0%
per trading day 0.8 20.8 2.5 23 47.1
Turnover ( mil.) 841 1,118 1,044 9,049 12,052
Mean size spot ( mil.) 4.4 0.2 1.6 1.6 1.02
Source: Reitz et al. (2010)

Empirical Evidence
Table 2: Spread variation across deal size and counterparty type
Oct..02 Sept. 03 (11,830 obs.)
Baseline MS Size Dummies Counterparty Dummies
Constant 0.21 (0.11)* 0.15 (0.11) 0.08 (0.11)
Deal Size Qit 0.34 (0.13)** Large 0.06 (0.08) Commercial 0.94 (0.17)***
Small 20.2 (2.10)*** Financial 0.09 (0.09)
Internal 0.29 (0.14)**
Inventory It 0.01 (0.07) Large 0.03 (0.07) Commercial 0.04 (0.07)
Small 0.03 (0.07) Financial 0.04 (0.07)
Internal 0.03 (0.09)
Lagged Inventory 0.001 (0.07) Large 0.04 (0.07) Commercial 0.03 (0.07)
It-1 Small 0.02 (0.07) Financial 0.05 (0.07)
Direction Dt 6.48 (0.20)*** Large 2.13 (0.21)*** Commercial 9.47 (0.19)***
Small 11.5 (0.26)*** Financial 2.04 (0.21)***
Internal 14.8 (1.08)***
Lagged Direction 5.82 (0.18)*** Large 1.17 (0.15)*** Commercial 9.84 (0.20)***
Dt-1 Small 10.3 (0.26)*** Financial 0.94 (0.15)***
Internal 14.3 (1.50)***
R2 0.23 0.33 0.34

Empirical Evidence
Oct..02 Sept. 03 (11,830 obs.)
Constant 0.21 (0.11)* 0.15 (0.11) 0.08 (0.11)
Small 20.2 (2.10)*** Financial 0.09 (0.09)
Internal 0.29 (0.14)**
Small 0.03 (0.07) Financial 0.04 (0.07)
Small 11.5 (0.26)*** Financial 2.04 (0.21)***
Internal 14.8 (1.08)***
Internal 14.3 (1.50)***
R2 0.23 0.33 0.34

Empirical Evidence
Oct..02 Sept. 03 (11,830 obs.)
Constant 0.21 (0.11)* 0.15 (0.11) 0.08 (0.11)
Small 20.2 (2.10)*** Financial 0.09 (0.09)
Internal 0.29 (0.14)**
Small 0.03 (0.07) Financial 0.04 (0.07)
Small 11.5 (0.26)*** Financial 2.04 (0.21)***
Internal 14.8 (1.08)***
Internal 14.3 (1.50)***
R2 0.23 0.33 0.34

Empirical Evidence
No price shading
Dealers tend to control inventory using
interdealer markets
Half spreads quite large for small
trades/commercial customers
Weight put on order flow information is
11% on average
54% for financial customers
Stat. insignificant for comm. and internal
customers
Empirical Evidence
No influence of deal size on prices

in case of financial customers
Is deal size uninformative?
Huang and Stoll (1997) suggest that traders split
up their orders into a number of standardized
transactions to prevent dealers from inferring
information from deal size!
Trade direction may thus remain as an
information conveying variable!

Bayesian Learning
1. Assume the customer is another bank

2. The bank observers the public signal yt
3. The private signal arises from deals of its
clients, e.g. firms are buying USD on average
4. This positive order flow might signal an
increase of the true value

Bayesian Learning
1. How is information contained in the order flow
revealed? An example!
Clients buy
1.2
Clients sell
Pt = 1
Clients buy
0.8
Clients sell

Bayesian Learning
1. Probabilities!
Clients buy
0.7
1.2
0.5 0.3 Clients sell
Pt = 1
0.5 0.4 Clients buy
0.8
0.6
Clients sell

Bayesian Learning
1. Probabilities!
Clients buy
P(bup)
1.2
P(up) P(sup) Clients sell
Pt = 1
P(do) Clients buy
P(bdo)
0.8
P(sdo)
Clients sell

Bayesian Learning
1. What is the probability that the true value has
gone up given that we observe clients buying?
2. Similarly

Bayesian Learning
1. From the numerical example, we have
2. Expected true value from order flow

Bayesian Learning
Given his prior (public) information
The weighting is derived from the precision of

signals
See the full derivation on OLAT

Outline: 1. Description of Foreign Exchange Trading

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Outline

1. Description of Foreign Exchange Trading

Prof. Reitz FX Markets - Theory and Empirics 1

2. The Dealers Perspective

Prof. Reitz FX Markets - Theory and Empirics 2

Source: Deutsche Bundesbank, MB 1/2008

Prof. Reitz FX Markets - Theory and Empirics 3

The Madhavan and Smidt 1991 model

di is the exchange rates innovation, so that the

The underlying stochastic process is the same

Prof. Reitz FX Markets - Theory and Empirics 5

Prof. Reitz FX Markets - Theory and Empirics 6

Prof. Reitz FX Markets - Theory and Empirics 7

Prof. Reitz FX Markets - Theory and Empirics 8

Under these circumstances the market

where t is the market makers expectation of

How does the market maker exploit available

Prof. Reitz FX Markets - Theory and Empirics 9

The customer additionally carries a private

wt = t + t , and t ~ iid . N (0, 2 )

Prof. Reitz FX Markets - Theory and Empirics 10

Customers demand function linear in the

Prof. Reitz FX Markets - Theory and Empirics 11

Market maker is unable to disentangle the

Prof. Reitz FX Markets - Theory and Empirics 12

Prof. Reitz FX Markets - Theory and Empirics 13

The market makers posterior mean is a

Pricing schedule of the market maker

Prof. Reitz FX Markets - Theory and Empirics 15

Prof. Reitz FX Markets - Theory and Empirics 17

Prof. Reitz FX Markets - Theory and Empirics 18

The last term is a public information signal and

Prof. Reitz FX Markets - Theory and Empirics 19

The coefficient = (1-)/() captures the

Prof. Reitz FX Markets - Theory and Empirics 21

Percent 1.6% 44.2% 5.4% 48.8% 100.0%

per trading day 0.8 20.8 2.5 23 47.1

Turnover ( mil.) 841 1,118 1,044 9,049 12,052

Mean size spot ( mil.) 4.4 0.2 1.6 1.6 1.02

Source: Reitz et al. (2010)

Prof. Reitz FX Markets - Theory and Empirics 22

Constant 0.21 (0.11)* 0.15 (0.11) 0.08 (0.11)

Prof. Reitz FX Markets - Theory and Empirics 23

Constant 0.21 (0.11)* 0.15 (0.11) 0.08 (0.11)

Prof. Reitz FX Markets - Theory and Empirics 24

Constant 0.21 (0.11)* 0.15 (0.11) 0.08 (0.11)

Prof. Reitz FX Markets - Theory and Empirics 25

No influence of deal size on prices

Prof. Reitz FX Markets - Theory and Empirics 27

1. Assume the customer is another bank

Prof. Reitz FX Markets - Theory and Empirics 29

Prof. Reitz FX Markets - Theory and Empirics 30

Prof. Reitz FX Markets - Theory and Empirics 31

Prof. Reitz FX Markets - Theory and Empirics 32

Prof. Reitz FX Markets - Theory and Empirics 33

2. Expected true value from order flow

Prof. Reitz FX Markets - Theory and Empirics 34

The weighting is derived from the precision of

See the full derivation on OLAT

Prof. Reitz FX Markets - Theory and Empirics 35

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