Foreign Exchange Hot Potato and Spread under E-trading Chen-Jui Huang*

This paper applies order flow analysis and develops an n-dealer hot potato trading model that characterizes the microstructure of the foreign exchange market. The model demonstrates that there converges a multiplier effect on total trading volume as interbank dealers commonly adopt the hot potato strategy to avoid position risk. It also suggests that the recent emergence of e-trading by dealers be an inverse shock on trading intensity over time. Moreover, the potential entry of nonbank participants into the market and continual consolidation in the global banking sector generate dynamics of market activities in opposite directions. A simple short-run spread determination model is also derived to examine the net impact of e-trading on the spread. Because of offsetting nature, the structural changes driven through the major determinants of the spread seem to lead to an ambiguous long-run outcome