Uninformed but Consequential: Corporate Trading in Over-the-counter FX Markets
59 Pages Posted: 29 Apr 2022 Last revised: 7 Feb 2023
Date Written: January 31, 2023
Abstract
We examine the role of multinational corporations in explaining the extraordinary volume and price volatility in foreign exchange (FX) markets. Corporations represent a distinct segment of discretionary traders with negatively correlated order flow to that of informed agents, which allows for internalization of dealers’ inventory. However, liquidity shocks experienced by them contribute to a “hot potato effect”: the repeated passing of dealers’ inventory imbalances. Using settlement breaks to instrument for quasi-exogenous shocks to liquidity-motivated trading, we find that a dollar increase in corporate volume leads to more than two dollars being exchanged in the inter- dealer segment. This hot potato effect exacerbates noise in currency prices, with a one standard deviation rise in corporate order imbalance leading to a 22% increase in return volatility. In contrast to other traders, spreads paid by corporations increase with volume, suggesting that dealers view large corporate flows as a source of inventory risk.
Keywords: Foreign Exchange, Market Microstructure, Information, Volatility
JEL Classification: F31, G12, G15
Suggested Citation: Suggested Citation