N°18-56: Dealer Heterogeneity and Exchange Rates

We show, both theoretically and empirically, that several statistics of dealer heterogeneity affect prices and liquidity in the foreign exchange (FX) market. A higher cross-sectional covariance between dealers’ risk aversions and inventories is associated with higher FX returns. Although unobservable, this statistic can be proxied by the cross-sectional covariance between dealer-to-customer (D2C) prices and bid-ask spreads. A higher cross sectional dispersion of dealer risk aversions is associated with higher liquidity in the dealer to-dealer market and can be proxied by the crosssectional dispersion of D2C spreads. These predictions are confirmed empirically using proprietary data on the largest FX dealers’ D2C quotes.