Profits and Position Control : A Week of FX Dealing

This paper extends earlier work on FX microstructure by answering a number of key quantity-dependent questions. Earlier work was unable to address these questions because direct measures of quantity (order flow) were not available. For example, how profitable is dealing in FX? And how rapidly do FX dealers dispose of risky inventory compared to, say, NYSE equity specialists? Other questions are less straightforward, requiring some methodological progress. For example, what share of dealer profits come from speculation versus intermediation? To answer this question one needs a method for measuring dealer speculation over time. This paper introduces a method for doing this. Our answers to these questions are striking. First consider dealer profits: the dealer we track averages $100,000 profit per day (on volume of $1 billion per day). By comparison, equity dealers average about $10,000 profit per day (on volume of roughly $10 million per day). Further, we find that these profits derive primarily from intermediation rather than speculation. We also find intense inventory management: the half-life of non-zero positions is only 10 minutes. This is remarkably short relative to half-lives for equity specialists of one week. Inventory theory is clearly essential to understanding trading in this market. Though striking, these results also present a challenge: Why do equity and FX markets look so different in these dimensions?