Incorporating derivative order flow in foreign exchange microstructure theory

This paper justifies the claim that orders on exchange rate derivatives, including forwards, swaps and options, have a place in exchange rate determination. A simple option model based on Kyle (1985) is presented illustrating that option order flow informs traders about expectations of future exchange rates. The model is placed in a complete market where options are replicable thus conveying the same information as spot orders. A proposal is made that forward order flow has a variable impact on spot rates, depending on the extent to which they are used in hedging activities and must be treated separately to spot orders. Finally, the construction of FX swap order flow could be achieved by considering only the spot leg of the swap transaction as the forward leg in a swap is necessarily a hedging tool with no effect on rates.

Grantor dc:publisher.institution

School of Economics

Year dc:date.issued

2008

Author dc:creator

• Condon, Kieran

Language dc:language.iso

eng

Handle dc:identifier.uri

http://hdl.handle.net/11427/5775

OAI identifier oai:identifier

oai:open.uct.ac.za:11427/5775