Why Are Asset Markets Modeled Successfully, But Not Their Dealers?

Abstract

Market-level microstructure models of asset pricing succeed where dealer-level models do not. This study addresses this empirical difficulty in the context of foreign exchange dealers. New evidence is presented rejecting the latter models' specifications of how information asymmetry and inventory accumulation affect dealer pricing. This rejection is consistent with those of other dealer-level empirical studies. A new modeling avenue may be to reconsider optimal price setting while relaxing assumptions that specify incoming orders as the only component through which dealer inventories evolve. This approach is consistent with inventory evolution data and with market-level models' assumptions about currency markets. Copyright 2005, International Monetary Fund