Trading Activity, Dealer Concentration and Foreign Exchange Market Quality

We study the relation between foreign exchange market quality and both trading activity and dealer concentration by considering two currency pairs with significant differences along both dimensions – the Euro-US dollar and Canadian dollar – US dollar. A variance ratio test reveals over-reaction in currency prices, but that this is smallest when trading activity is high and dealer concentration at its peak. A GARCH model shows that over-reaction declines as trading activity and dealer concentration increase, with the results being stronger for the Euro. Our results confirm that trading activity is an important determinant of market quality, but also point to a significant role for dealer concentration