A Study of the Price Distribution in Foreign Exchange

Abstract: The aim of this thesis was to develop models that can indicate at what relativelevel orders should be placed to obtain a specific market share in foreign exchange(FX). This was conducted at the E-markets department at SkandinaviskaEnskilda Banken (SEB). To understand how trades occur, the Skew-function wasdeveloped. It is a suitable model for visualizing the price distribution withinthe spread, and can be used as an indicator for order placements in relation tomarket share.Another aim was to find at what level orders should be placed in the marketto obtain a maximized revenue. To reach this goal, the Optimal-skew modelwas developed. The Optimal-skew model visualizes how many percentagesone needs to decrease into the spread in order to obtain a maximized revenue,with the condition of obtaining a required market share within a specific timeframe. The model also demonstrates the time horizon that probably will lead tothe highest revenue, when the required market share is set.By testing the models with error metrics and backtesting, it was possible toapproximately predict and forecast how the FX markets would behave in thefuture. With the forecast ability, it was in advance possible to know how tradeswould occur and therefore possible to take advantage of a deterministic marketbehavior. Both models indicate how markets differ from each other, and themarket which is the most beneficial one to act on.The models can be applied to any currency pair and market, but have in thisthesis been focused on the EUR/USD instrument. These models could, if implementedcorrectly, generate a more deterministic view of the market, and resultin more efficient trades, as well as better placement of orders. This should,as a consequence, provide better conditions for high-frequency trading withinforeign exchange.