An Intraday Pricing Model of Foreign Exchange Markets, Issues 2003-2115
Market makers learn about asset values as they set intraday prices and absorb portfolio flows. Absorbing these flows causes inventory imbalances. Previous work has argued that market makers change prices to manage incoming flows and offset inventory imbalances. This study argues that they have multiple instruments, or ways to manage inventory imbalances and learn about evolving asset values. Hence, they smooth inventory levels and update prior information about assets using multiple instruments. In ignoring other instruments, previous studies have ignored the information that these provide and overemphasize the role of price changes in inventory management. The model presented here 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.
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appendix shows asset value asymmetric information effect changes her price coefficients column conjectured functional cost of liquidity daily volume denoted dollar equation example Exchange Rates Fed intervention Financial Economics foreign exchange markets Frankel Froot full information value FX markets Hence implies incoming order flow incoming trades induce trades inter-transaction interdealer intraday inventory carrying cost inventory costs inventory evolution inventory imbalances inventory level inventory management inventory shocks Journal of Financial Kalman filter linear Lyons Madhavan and Smidt manage inventory market maker million Fed misspecification model presented model solution multiple instruments NYSE optimal inventory outgoing order flow P-values parameters percent pips portfolio flows previous estimates previous models price changes price impact price setting price-induced quantity shock Ramadorai random walk rational expectations risky asset robust source of information specialist Subsection Table trade q unexpected incoming order unexpected order flow updating priors variables variance Wall Street Journal