Abstract
The paper proposes a continuous time model of an FX market organized as a multiple dealership. The dealers have costly access to best available quotes.
They interpret signals from the joint dealer-customer order flow and decide upon their own quotes and trades in the inter-dealer market. Each dealer uses the observed order flow to improve the subjective estimates of relevant aggregate variables, which are the sources of uncertainty.
The risk factors are returns on domestic and foreign assets and the size of the cross-border dealer transactions in the FX market. These uncertainties have diffusion form and are dealt with according to the principles of portfolio optimization in continuous time.
The model is used to explain the country, or risk, premium in the uncovered national return parity equation for the exchange rate. The two country premium terms that I identify in excess of the usual covariance term (consequence of the "Jensen inequality effect") are: the dealer heterogeneity-induced inter-dealer market order flow component and the dealer Bayesian learning component.
As a result, an "order flow-adjusted total return parity" formula links the excess FX return to both the "fundamental" factors represented by the differential of the national asset returns, and the microstructural factors represented by heterogeneous dealer knowledge of the aggregate order flow and the fundamentals.