A Hierarchical-Dealer Centric Model of FX Swap Market Microstructure

Abstract

This paper constructs a model of the foreign exchange (FX) swap valuation based on the dealers’ behavior and the hierarchy of international finance. International investors use these currency derivatives to fill their US-Dollar funding gaps synthetically. In this model, three fundamentals-market-making costs (measured by dealers’ bid-ask spreads), dollar funding liquidity risk (measured by CIP deviation and market imperfection), and the FX swap market liquidity (measured by the dealers’ competition)- derive the valuation of the FX swaps. The goal is to understand the international spillovers between FX swaps and offshore US-Dollar funding markets through the “dealers” channel. FX dealers are vital institutions that connect different national monetary jurisdictions in the international monetary system. For currencies where FX turnover is low, market makers are central banks. On the other hand, those dealers are primarily private banks for currencies with the highest FX turnover. Nevertheless, studying the “dollar funding gap” through the lens of FX swap dealers is a feature that often gets overlooked in International Finance scholarship

Keywords: Foreign exchange, Liquidity, International Finance, Dealers, Microstructure, Financial Stability

JEL Classification: F31, G31, F33, G23, L22, E44