An empirical analysis on price transmission is useful since it has important implications for market participants. In the present paper we have utilized the unique and high frequency FX dataset to provide further insights into the long-term equilibrium and short-run dynamics of the two foreign exchange markets in Taiwan.
First, we examine the extent to which liquidity-demanding dealers could obtain better terms by submitting market bid or market ask orders in the two different markets. The optimal trading timing in TFE is higher, but the mean saving on trading in CFE is greater. The results reveal opportunities for interbank dealers to save money by transacting in one of the two markets, depending on the market conditions.
Second, we estimate vector error correction models based on transaction price, ask price, and bid price, respectively. For the transaction price and ask price, the major market of TFE is the dominant market, especially during the market opening and closing intervals. This finding is consistent with most previous studies on other financial markets, but contrary to Kao and Wan (2012) and Wan and Kao (2009), who examined daily frequency data in Taiwan’s two FX markets before 2009. A dealer’s objective is often to find the best price via submitting separate market or limit orders into the two markets. Thus, the minor market with a lower best bid price in most cases, CFE, acts as the dominating market and provides more contribution to price discovery for the bid price.
The dominant-satellite relationship between the two foreign exchange markets gradually decreases when the sampling frequency is lower. In particular, the coefficients of error correction terms are insignificant at the 60-minute sampling frequency. This indicates the importance of using intraday frequency in exploring price discovery in a foreign exchange market. Finally, this paper confirms that the major market truly maintains a leading relationship to the minor market in terms of liquidity.
Understanding currency price trends must rely on information transmission and price discovery in the two FX markets. This not only serves dealers as an indicator to actively adjust their order-submitting strategies in response to any
deviation from the equilibrium, but also facilitates future research into the intervention effect of the Central Bank of Taiwan.
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