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Information or Market Power: What is Governing Dealers’ Pricing Behaviour in FX Markets?

An Investigation in the Spirit of the Microstructure Approach to Exchange Rates

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Markus Alexander Schmidt

The microstructure approach provides valuable insights into high-frequent exchange rate dynamics. Recent studies, including this book, evidence the prominence of information asymmetries for asset pricing as well as order flow’s important role during information aggregation processes via trading. However, results indicate that dealers quote prices in contrast to predictions of standard theory of asset pricing under asymmetric information. By analysing a unique data set of EUR/USD transactions at a German bank, this work investigates whether this pricing behaviour is due to dealers’ strategic dealing considerations or traders’ relative market power. The study concludes that it is market power rather than strategic dealing that determines dealers’ pricing strategy.
Contents: Becoming acquainted with microstructure finance – Investigating dealers’ pricing behaviour in FX markets – Strategic dealing hypothesis – Market power hypothesis – Information content of order flow – Market power and FX pricing behaviour.