Order Flows, Delta Hedging and Exchange Rate Dynamics
This paper proposes a microstructure model of the FX options and spot markets. On both market segments, dealers receive customer order flows and use this private information strategically to speculate during interdealer rounds. This non-payoff information is first impounded in private dealers' inventories before affecting prices. Derivative trading impacts the equilibrium exchange rate via the feedback effect of delta hedging strategies followed by option dealers to cover the FX risk embedded in their options portfolio. It is shown that depending on the correlation between spot and option order flows, the volatility of the exchange rate can either be amplified or reduced.
FX microstructure model; feedback effect; delta hedging; order flows; implied volatility
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