| Popis: |
Foreign exchange operates as a two-tiered over-the-counter (OTC) market dominated by large, strategic dealers. Using proprietary high frequency data on quotes by the largest foreign exchange dealer banks in the dealer-to-customer (D2C) market, we find a significant heterogeneity in their behavior. We develop a model of strategic competition that accounts for this heterogeneity and the two-tier market structure and allows us to link prices and bid-ask spreads in the D2C and dealer-to-dealer (D2D) market segments. We use the model to recover dealers' risk aversions and inventories from their quotes in the D2C segment and construct an endogenous measure of systemic, non-diversi able risk capturing the cross-sectional liquidity-risk mismatch. Consistent with the model predictions, we find that liquidity mismatch positively predicts prices in the D2D market whereas the cross-sectional dispersion in dealer D2C spreads negatively predicts the level of spreads in the D2D market. |
