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Abstract
This paper develops a simultaneous trade model of the spot foreign exchange market (cf.,
the sequential trade approach to dealing). The model produces hot-potato trading – a term
that refers to the repeated passing of inventory imbalances between dealers. At the outset,
risk-averse dealers receive customer orders that are not generally observable. Dealers then
trade among themselves. Thus, each dealer intermediates both his customers’ trades and any
information contained therein. This information is subsequently revealed in price depending
on the information in interdealer trades. We show that hot-potato trading reduces the
information in interdealer trades, making price less informative.
‘[When hit with an incoming order, a currency dealer] seeks to restore its
own equilibrium by going to another marketmaker or the broker market for a
two-way price. A game of ‘hot potato’ has begun . . . It is this search process
for a counterparty who is willing to accept a new currency position that
accounts for a good deal of the volume in the foreign exchange market-
.’(James Burnham, 1991)
1. Introduction
Trading volume in spot foreign exchange (FX) dwarfs that in other financial
markets. Yet, exchange rate models have little to say about volume, much less the
degree to which volume conveys useful information. Progress on these issues
demands a microstructure approach, one that can address an existing gap between
two literatures: (i) the macro approach to FX and (ii) the microstructure approach
to markets quite different than FX (i.e., specialist and auction markets). This paper
addresses the gap. The principal objectives are to model the institutions specific to
FX and to clarify how information is aggregated within markets of this type.
The FX market is distinctive at the microstructural level. Three characteristics
are particularly striking. First, as noted above, trading volume dwarfs that in other
financial markets. Second, roughly 80% of this trading is interdealer, a much
higher share than in other multiple-dealer markets. (The remaining 20% being
between dealers and non-dealer customers.)1 And third, though FX’s multiple-
dealer configuration is shared by other markets (e.g., NASDAQ), its informational
configuration is not. Specifically, the transparency of order flow in FX is lower
than in comparable markets: NASDAQ trades must be disclosed within minutes by
law, whereas FX trades have no disclosure requirement. A consequence is that
trades between FX dealers and their customers are not observed by others. An
interesting contrast, however, is that interdealer trades are partially observable,
though as a by-product of the methods used for interdealer trading rather than from
any disclosure requirement (described more fully in Section 2).
Our model emphasizes key institutional features. It includes n risk-averse
dealers who receive customer orders that are not observed by other dealers.
Dealers then trade among themselves. This interdealer order flow becomes the
basis for period-two prices. Three key features are embedded in this structure.
First, it includes risk aversion: there is strong evidence that risk aversion drives
dealer behavior in this market [Lyons (1995)]. Second, in addition to intermediat-
ing customers’ orders, dealers also intermediate any information contained therein.
The effects of this intermediation on subsequent information aggregation is central
to our analysis. Third, with interdealer trades driving price, the model captures the
effect of different transparency across trade types, customer–dealer versus
interdealer: because customer–dealer trades are not generally observable, they are
not aggregated in price until later reflected in interdealer trades – which are
observable. The result is a two-stage process of information aggregation, with
interdealer trading as the second, crucial stage.
Our simultaneous trade approach is distinct from other trading models in the
literature [e.g., the rational expectations model of Grundy and McNichols (1989),
the sequential trade model of Glosten and Milogrom (1985), the multiple dealer
1
See New York Federal Reserve Bank (1995). The customer share of NASDAQ and SEAQ volume is
less than 40% [see Reiss and Werner (1994) and Morgenson (1993)].
R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298 277
model of Ho and Stoll (1983), and the auction model of Kyle (1985)]. We feel that
the nature of the FX market and the questions we wish to address demand a
different approach. Let us begin by contrasting our model with the rational
expectations models. Ours departs in two key ways: (i) dealers cannot condition
on market-clearing price before submitting orders, and (ii) dealers must contend
with inventory shocks. Because dealer orders are not conditioned on market-
clearing price, order flow remains relevant for information aggregation over
multiple trading rounds. For understanding FX volume, we consider this type of
staged learning a more realistic approach. Put differently, in our model orders
precede price, in the sense that innovations in order flow drive subsequent price
adjustment [also a property of Kyle (1985), though he models an auction market,
not a dealer market]. This contrasts with rational expectations models in which
price precedes orders, in the sense that market-clearing price is the basis of all
orders. In our model, in fact, private information is reflected in price only if it is
first reflected in orders (which we term the strict precedence of orders).2 In the end,
the strict precedence of orders in our approach provides the sharpest possible
contrast to the assumption in rational expectations models that market-clearing
price is known.
The second way we depart from the rational expectations models – introducing
inventory shocks – provides a role for undesired inventories, which is essential for
capturing the hot-potato process described above by Burnham (1991).3 Rational
expectations models neglect this since they have the property that traders are on
their demand curves at all times. This property is difficult to reconcile with the
view of Flood (1994): ‘the large volume of interbank trading is not primarily
speculative in nature, but rather represents the tedious task of passing undesired
positions along until they happen upon a marketmaker whose inventory dis-
crepancy they neutralize.’ Lyons (1996a,b) provides empirical evidence supportive
of the hot-potato hypothesis.
2
Using quotes to signal private information is never optimal in our model. This property comes from
the avoidance of being arbitraged. Empirically, avoiding being arbitraged is indeed a first-order concern
for FX dealers: quotes are good for much larger quantities than in other dealer markets ($10 million in
DM / $); and spreads are so tight they leave little room for using quotes to signal (less than 0.02%). Of
course, arbitrage does not preclude positioning a non-zero spread to induce trade at one side of the
market. In fact, there is empirical evidence that this occurs [Lyons (1995)]. Nevertheless, the evidence
indicates that dealers do this for inventory control, rather than information signalling.
3
Though Ho and Stoll (1983) develop a multiple-dealer model, theirs cannot capture hot-potato trading
because each dealer is competitive on one side of the market only. (Moreover, their model cannot
address information aggregation since trading is allocational, not informational). For hot-potato trading,
crucial to our model is the simultaneous trade feature, which contrasts with the usual sequential trade
approach to dealing [Glosten and Milgrom (1985)]. The term simultaneous trade captures our modeling
of trade among dealers as a game with simultaneous and independent moves. Specifically, when
determining their trades dealers cannot condition on the trades of other dealers in the same period. This
simultaneous trade feature has the advantage that it integrates position disturbances and dealing in a
natural way.
278 R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298
We begin with four features of FX microstructure that are central to the model
of Section 3. These observations benefit from a number of days seated next to
R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298 279
D-Mark dealers at major New York banks. For additional institutional detail see
Burnham (1991).
1. Dealers emphasize the importance of customer order flow, and each has some
understanding of the motives behind own-customer trades. As described by
Citibank’s head of FX in Europe ‘If you don’t have access to the end user your
view of the market will be severely limited’ (Financial Times, 4 / 29 / 91). In a
similar spirit, Goodhart (1988) writes: ‘A further source of informational
advantage to the traders is their access to, and trained interpretation of, the
information contained in the order flow . . . Each bank will also know what
their own customer enquiries and orders have been in the course of the day, and
will try to deduce from that the positions of others in the market, and overall
market developments as they unfold.’ Note that banks have virtually no direct
information regarding other banks’ customer orders.
2. Dealers garner order-flow information from interdealer trades that are handled
by brokers, accounting for about one third of total volume. (Brokers do not take
positions, and intermediate interdealer trades only.) This point is new to the
literature, to the best of our knowledge, and is important to our model. This
information is communicated to all dealers via intercoms linked to the handful
of relevant brokers (or, more recently, via screens from electronic brokers such
as EBS). When a transaction takes place that exhausts the advertised bid or
offer, this fact is announced. For example, if a broker is advertising DM
1.6045–1.6050 per dollar, and a buyer of dollars exhausts the quantity on offer,
the broker will announce 50 paid, which indicates that a transaction was
initiated at the offer. Though the exact size is not known, this still represents a
signal of order flow since dealers have a sense of the typical size [Lyons (1995)
reports a median brokered quantity of about $5 million]. The clearing of the bid
or offer at a given dealer accounts for about 50–75% of brokered transactions,
depending on the currency (dealer estimates). The important point is that this is
the only market-wide signal of order flow available.
3. There are times when a given dealer will feel strongly about the mispricing of
FX and will deliberately take a substantial open position. Often, however,
deliberate open positions are small relative to order flow.
4. Undesired open positions are frequent and non-trivial. They are a natural
consequence of marketmaking with risk-averse dealers, fast-paced trading, and
very tight spreads.
The model of the following section makes ample use of these four features of the
FX market. In particular: (i) customer order flow is the source of information
asymmetry among dealers; (ii) interdealer trading drives price determination via
transparency akin to that provided by brokers; (iii) dealers exploit the information
contained in own-customer orders in taking speculative positions; and (iv) dealers
280 R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298
must contend with the unavoidable position disturbances that result from market-
making. Feature (iv) is perhaps the most distinctive of our model, one that does
not arise in standard two-period rational expectations models. It is essential for
capturing the hot-potato process noted above.
c˜ i 5 c˜ 1 x˜ i (1)
s˜ i 5 c˜ 1 j˜i (2)
s˜ 5 c˜ 1 h˜ (3)
c˜ 5 F˜ 1 n˜ (4)
Here, c i denotes the net of all customer market-orders received by dealer i,
positive for net customer purchases and negative for net sales. c i is not observed
by other dealers. Eq. (1) decomposes c i into a component common to all dealers,
and a private component x i . The components are not individually observed. Per
Eq. (4), the common component c is correlated with the full-information value F;
4
This assumption of zero initial supply simply obviates the need – ex-ante – for bias in prices to
induce holding of the net supply. Relaxing it has no substantive impact on our analysis.
R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298 281
Fig. 1. Timing of events and information. Notation: c i denotes the net customer market-order received
by dealer i; s i denotes dealer i’s signal of the component common to each c i , i51, . . . ,n; s denotes the
public signal of the component common to each c i , i51, . . . ,n; Pi1 denotes dealer i’s quote in period
one; T i1 denotes dealer i’s net outgoing orders to other dealers in period one; T 9i1 denotes dealer i’s net
incoming orders from other dealers in period one; V denotes net interdealer order flow in period one;
and F denotes the full-information value of the risky asset (foreign exchange). The information sets at
the four decision nodes – two quoting and two trading – appear below the time line.
the noise n is independently and normally distributed about zero with known
variance Sn . The private component x i is independently and normally distributed
about zero with known variance Sx .
There are two initial signals available to dealer i for disentangling the
components of c i , one public and one private. Eq. (2) describes the private signal
s i . The noise j i is independently and normally distributed about zero, with known
variance Sj . Eq. (3) describes the public signal s. The noise h is also in-
dependently and normally distributed about zero with known variance Sh . The
signals s i and s are observed simultaneously with c i .
At least two sources of correlation between customer orders and full-in-
formation value are plausible. First, purely liquidity-motivated customer orders
may be informative. For example, suppose aggregate net exports is a component of
full-information value. In this case customer-orders may reveal information about
firm-level export performance that must be aggregated (but is not yet published
282 R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298
The next two events are common to both periods: dealer quoting and interdealer
trading. Customer market-orders, which occur only in period-one, are cleared at
the respective dealer’s period-one quote. Let Pit denote the quote of dealer i in
period t. The rules governing the quotes Pit are:
(R1) Quoting is simultaneous and independent (thus quotes are not conditioned
on other quotes).
(R2) Quotes are observable and available to all dealers.
(R3) Each quote is a single price at which the dealer agrees both to buy and sell.
(R4) Quotes are good for any size.5
(R5) Dealers cannot refuse to quote.
Simultaneous moves are consistent with the fact that interdealer FX transactions
are typically initiated electronically rather than verbally, providing the capacity for
simultaneous quotes, trades, or both. Accordingly, here a period should be viewed
as the time it takes to make a trade, a span measured in seconds rather than hours,
days, or weeks. Rule 2 – the assumption that quotes are observable – is
tantamount to assuming that quote search is costless. The last rule prevents a
dealer from exiting the game at times of informational disadvantage. In actual FX
markets, dealers who choose not to quote during regular hours are viewed as
breaching the implicit contract of quote reciprocity, and are punished by other
dealers (e.g., breaches are met with subsequent refusals to provide quotes, or by
quoting large spreads).
The next event in both periods is interdealer trading. Let T i t denote the net of
outgoing interdealer orders placed by dealer i in period t; let T i t9 denote the net of
incoming interdealer orders received by dealer i in period t, placed by other
dealers. The rules governing interdealer trading are as follows:
(R6) Trading is simultaneous and independent (thus T it is not conditioned on
T i t9 .
(R7) Trading with multiple partners is feasible.
(R8) Trades are allocated to the dealer to the immediate left if there are
common quotes at which a transaction is desired (dealers are arranged in a circle).
Rule (R6) generates an important role for T it9 in the model: because interdealer
trading is simultaneous and independent, T it9 is an unavoidable disturbance to
5
The sizes tradable at quoted prices in the FX market are very large relative to other markets, as cited
above. See also Pithyachariyakul (1986) and Mendelson (1987) for models with prices that are
independent of size.
R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298 283
dealer i’s position in period t that must be carried into the following period. (See
Feature 4 of the previous section.) Trading rule (R8) also deserves attention. The
restriction that trades are not split if quotes are common can be relaxed. For
example, allowing a split into m,n equal fractions is straightforward as long as m
is known. (An unknown m, however, becomes intractable since it generates a
non-normal position disturbance.)
For consistency with our previous definition of c i as positive for net customer
purchases, orders will always be signed according to the party that initiates the
trade. Thus, T it is positive for dealer i purchases, and T i t9 is positive for purchases
by other dealers from dealer i. Consequently, a positive c i or T i t9 corresponds to a
dealer i sale. Letting Dit denote dealer i’s desired position in the risky asset net of
customer and dealer orders, we have by definition:
where VTi1 and VTi2 denote dealer i’s information sets at the time of trading in
periods one and two, respectively (see Fig. 1). From Eq. (5) it is clear that
customer-orders must be offset to establish the desired position Di1 . In addition, to
establish Dit dealers must factor the expected value of T 9it into their trades. In
period two, the realized period-one position must be reversed, which has the three
components: Di1 , T 9i1 , and E[T i 91 uVTi1 ] (recall that T 9i1 .0 corresponds to a dealer i
sale in period one).
At the close of period two dealers observe the full-information value F. At the
close of period one dealers observe period-one interdealer order flow:
OT .
n
V; i1 (7)
i51
The net order flow o i T i 1 measures the difference in buy and sell orders since T i 1
is negative in the case of a sale. The empirical analogue of V is the signed
order-flow information communicated by broker intercoms; this statistic is
common to all dealers and constitutes the core of their information set (see Feature
(2) of the previous section). Note that we specify this statistic as an exact measure,
which maximizes the transparency difference across trade types (customer–dealer
with zero transparency and interdealer with complete transparency). As noted in
the introduction, trades between dealers and their customers do indeed have zero
transparency. The actual transparency of interdealer trades is not complete
however. Since the results that follow do not require noise here, we stick to this
284 R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298
Each dealer determines her quotes and demands for the risky asset by
maximizing a negative exponential utility function defined over nominal wealth at
the close of period two. Letting Wi j denote the end-of-period j wealth of dealer i,
we have:
s.t. Wi2 5 Wi0 1 c i (Pi1 2 P 9i1 ) 1 (Di1 1 E[T 9i1 uVT i1 ])(P i2
9 2 P i19 )
1 (Di2 1 E[T 9i2 uVT i2 ])(F 2 P 9i2 ) 2 T 9i1 (P 9i2 2 Pi1 ) 2 T 9i2 (F 2 Pi2 )
Define the quoting strategy profile P;[(P1 1 ,P1 2 ), . . . ,(Pn 1 ,Pn 2 )] and trading
strategy profile T;[(T 1 1 ,T 1 2 ), . . . ,(T n 1 ,T n 2 )]. The following equilibrium concept
is applicable:
Definition 1:
A perfect Bayesian equilibrium (PBE) of the above game is a belief-strategy
profile pair that for all period 1 outcomes and for all i satisfies the following
conditions:
A quoting and trading strategy pair (P,T ) is sequentially rational if, for any
ˆ ˆ the following condition holds:
alternative strategy pair (P,T),
ˆ
with P;[(P ˆ ˆ
11 , P12 ), . . . , (Pi21,1 , Pi21,2 ), (Pi1 , Pi2 ), (Pi11,1 , Pi11,2 ), . . . ,(Pn1 , Pn2 )]
ˆ ˆ ˆ i2 ), (T i11,1 , T i11,2 ), . . . ,(T n1 , T n2 )]
and T;[(T 11 , T 12 ), . . . ,(T i21,1 , T i21,2 ), (T i1 , T
In solving for the symmetric PBE, first we consider some properties of optimal
quoting strategies. The following proposition addresses period-one quotes. For the
proposition, define the signal extraction coefficients lFc ; SF /Sc and lcs ; Sc /Ss
(i.e., lFc extracts F from c), where Sc 5 SF 1 Sn and Ss 5 Sc 1 Sh .
The value of the constant Ls1 is presented in Table 1 (recall that all proofs are in
Appendix A). Here, we provide some intuition for the result. First, rational quotes
must be common to avoid arbitrage since quotes are singleton prices, are available
to all dealers, and are good for any size. The overshooting result is necessary to
induce dealers to hold the average inventory disturbance arising from the common
component c. To see this, suppose P1 is unbiased conditional on public in-
formation. In that case, dealers have no incentive to hold the average inventory
disturbance, and would try to unload it in interdealer trading. However, it is
inconsistent with equilibrium for dealers to expect the non-zero average to
disappear as a result of period-two trading since they are trading among
themselves. Rather, in equilibrium, if s implies that c is negative (customers are
selling), then dealers are long on average since they take the other side. To induce
them to hold the long position, price must be expected to rise. Hence, the initial
price fall must overshoot to make room for the expected rise that compensates
dealers for their positive inventories.
An implication of common quotes is that each dealer receives exactly one order
from another dealer in period one (per trading rule (R8)). This order corresponds
to the position disturbance T i1 9 in the dealer’s problem in Eq. (8). The next
proposition addresses optimal period-two quotes:
The values of the constants Ls2 and LV are presented in Table 1. The no-arbitrage
argument that establishes this result is the same as that for proposition 1. And like
286 R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298
Table 1
Coefficient values
Deep parameters: n, u, SF , Sn , Sx , Sj , Sh .
Sc 5 SF 1 Sn
lFc 5 SF /(SF 1 Sn )
lcs 5 Sc /(Sc 1 Sh )
SZ1 5(1/n)[ b11 /( b11 1 b21 )] 2 Sx 1(1/n)[ b21 /( b11 1 b21 )] 2 Sj
SZ2 5(n21)21 [ b11 /( b11 1 b21 )] 2 Sx 1(n21)21 [ b21 /( b11 1 b21 )] 2 Sj
SZ3 5( b11 1 b21 )2 b 22 2 21
11 Sc 1( b21 /b11 ) n Sj
SV9 5(n21)2 ( b11 1 b21 )2 (S 21 21 21 21 21
c 1S x 1S j 1S h )
2
1(n21)b 11 2
Sx 1(n21)b 21 Sj
SEc 51/(S 21 21 21 21 21
c 1 S x 1 S j 1 S h 1 S Z2 )
S2 5 SEc 1 Sn
ls2 5[S 21 21 21 21 21
h 2 S Z1 ( b31 2 b41 Ls1 )/( b11 1 b21 )]/(S c 1 S h 1 S Z1 )
lV 5[SZ1 n( b11 1 b21 )(S 21 21 21 21
c 1 S h 1 S Z1 )]
Ls2 5uS2 lcis 1 lFc ls2
LV 5uS2 lciV 1 lFc lV
lcis 5 ls2 2[Sx /(Sx 1 SZ3 )](1/b11 )( b31 2 b41 Ls1 )
lciV 5 lV 1[Sx /(Sx 1 SZ3 )](1/nb11 )
Ls1 5(G/u )[ lcs ( b11 1 b21 2dci 2dsi )1 b31 2ds ]
lZ4 5 Sx /[Sx 1( b11 1 b21 )2 b 22 2
11 SEc 1( b21 /b11 ) Sj ]
fci 5 lFc SEc S x21 2 lFc SEc S Z2
21
[(n21)( b11 1 b21 )] 21 b11
fsi 5 lFc SEc S j21 2 lFc SEc S 21
Z2 [(n21)( b11 1 b21 )]
21
b21
fs 5 lFc SEc S 21 21 21
h 2 lFc SEc S Z2 n[(n21)( b11 1 b21 )] ( b31 2 b41 Ls1 )
21 21
fV 5 lFc SEc S Z2 [(n21)( b11 1 b21 )]
dci 5( b11 1 b21 )rci dsi 5( b11 1 b21 )rsi ds 5( b11 1 b21 )rs 1 b31 2 b41 Ls1
rci 5 S 21 21 21 21 21
x /(S c 1 S x 1 S j 1 S h ) rsi 5 S j21 /(S c21 1 S x21 1 S j21 1 S h21 ) rs 5 S h21 /(S c21 1 S x21 1 S j21 1 S h21 )
gci 5 LV (11dci ) gsi 5 LVdsi gs 5 LVds 1 Ls2
pci 5 fci 1(fV 2 LV )(11dci ) psi 5 fsi 1(fV 2 LV )dsi ps 5(fs 2 Ls2 )1(fV 2 Lv )ds
pD 5 fV 2 LV pV9 5 fV 2 LV
21 21 21
X1 5 pD pV9 S 2 1uLV X2 5 pci pV9 S 2 2(n21)dci S V9
21 21 21 21
X3 5 psi pV9 S 2 2(n21)dsi S V9 X4 5 ps pV9 S 2 2(n21)ds S V9
21 2 21 2 21 2 21
A5 S V9 1 p V9 S 2 G5X 1 A 2 p D S 2 22uLV
b11 511dci 1(ugci 1 pD pci S 221 2X1 X2 A21 )/G b21 5dsi 1(ugsi 1 pD psi S 221
21
2X1 X3 A )/G
b31 5ds 1(ugs 1 pD ps S 221 2X1 X4 A21 )/G b41 5u /G
b12 5 fci (uS2 )21 2( b11 212dci )2dci 1dci2 b22 5 fsi (uS2 )21 2 b21 22dsi 1dsi2
21
b32 5 fs (uS2 ) 2( b31 2 b41 Ls1 2ds )2ds 1ds2 b42 511dT92
b52 5 fV (uS2 )21 1dV2 b62 5(uS2 )21
dci2 5JK(S 21 21 21
x 2RS Z2 b11 )2 b42 (n22) b11 dsi2 5JK(S j21 2RS Z2
21
b21 )
21
2 b42 (n22) b21
21 21
dT92 5JlZ4 b 11 1( b22 /b21 )2 b42 (n22) dV2 5JKRS Z2 1 b42 (n22)21 1
21
( b52 2 b62 LV
ds2 5JKS 21 21 21 21
h 2[JlZ4 b 11 1nJKRS Z2 1 b22 /b21 1 b42 (n22) ]( b31 2 b41 Ls1 )1 b32 2 b62 Ls2
21 21
J5 b12 2( b22 b11 /b21 ) K5[12 lZ4 b 11 ( b11 1 b21 )]SEc R5[(n21)( b11 1 b21 )]
information not reflected in P2 becomes the basis for speculative dealer demands
in period two.
9 1 b52V 2 b62 P2
T i2 5 b12 c i 1 b22 s i 1 b32 s 1 b42 T i1
The values of the b coefficients are presented in Table 1. Recall that the quoting
rules for P1 and P2 are linear in hsj and hs,V j, respectively. The trading rules have
a corresponding linear structure deriving from exponential utility and normality,
which generate a linear demand function. The derivations in Appendix A ensure
that the quoting and trading strategies are mutually consistent and sequentially
rational.
6
Though less interesting, this model can also generate a within-period passing of purely extraneous
orders. That is, without altering prices, adding the same constant for each dealer to the trading rules in
proposition 3 is also a PBE.
288 R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298
This result comes from dealers recognizing that their own orders will have a
subsequent price impact. This induces each to alter speculative demand to profit
from the forecastable distortion in price. These altered speculative demands
exacerbate the reduced efficiency of signal extraction due to hot-potato trading
(proposition 5).
A simple example illustrates this. Suppose Sx 5 Sj , so that the precision of the
signals c i and s i is the same. Suppose also that dealer i observes the triplet
hc i ,s i ,sj5h1,21,0j. Since the value of s pins down P1 , we have P1 50. Further,
since c i and s i have the same precision, E[Fuc i ,s i ,s]50 and E[T i1 9 uc i ,s i ,s]50.
However, since T i1 includes c i directly, and since P2 moves in the direction of T i1 ,
dealer i’s speculative demand is not zero, but positive in order to profit from the
market’s interpretation of the c i in T i1 . (This is the asymmetry reflected by the 1
term in gci that does not appear in gsi .) Note that the increased relative weight on c i
in this example is not an artifact of the specific realization h1,21,0j: the weights in
the trading rule are not realization dependent. To summarize, the effects of
R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298 289
strategic behavior on the two weights are not equiproportional because c i affects
S
D i1 in two ways: through E[Fuc i ,s i ] and through the P2 -distorting effect of c i in V;
S
in contrast, s i affects D i1 only through E[Fuc i ,s i ].
Propositions 5 and 6 demonstrate that an information externality is present. The
externality arises because dealers are playing two roles in the market: that of
risk-averse speculator and that of information intermediary. The motivation of the
risk-averse speculator interferes with the process of information intermediation,
reducing the degree to which prices reveal information.
More generally, propositions 5 and 6 show that hot-potato trading hampers the
aggregation of a particular type of information: that which does not derive from
order flow (s i in our model). The following proposition extends propositions 5 and
6 to encompass the seven deep parameters in the first line of Table 1.
Proposition 7: Holding constant the information parameters hSF ,Sn ,Sx ,Sj ,Sh j,
variations in the remaining deep parameters h n,uj that reduce the relative weight
of non-order-flow information s i in T i 1 exacerbate the information externality.
Thus, for example, to the extent that higher risk aversion u reduces Di1 , and
thereby reduces the relative weight of s i in T i1 , the precision of the signal in T i1 is
reduced. The result is a less informative price P2 .
5. Conclusions
The objectives of this paper were two: (i) model the key institutional features of
FX, and (ii) clarify the process of trading and information revelation in a market
of this type. With respect to institutional features, there are three main lessons.
First, customer bases introduce a source of private information at the dealer level:
each dealer has sole knowledge of his own-customer order flow. Second, the
trading that occurs through brokers in this market plays an important informational
role since it provides the only market-wide signal of order flow to dealers. Third,
since roughly 80% of FX volume is interdealer, trading models for FX need to
address the interdealer dimension.
With respect to our second objective – clarifying the process of trading and
information revelation – there are also three main lessons. First, trading and price
adjustment occur even in non-event periods (i.e., even when there is no news
beyond that in the trading process itself).7 Second, risk aversion and strategic
marketmaking generate an information externality. This is because dealers play
two roles in the market: that of risk-averse speculator and that of information
intermediary. The motivation of the speculator distorts information intermediation,
7
This point should speak to those who have observed hours of frenzied spot trading with no apparent
changes in macro fundamentals. See also Romer (1993) on this issue.
290 R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298
Acknowledgments
Appendix A
Information sets
Conditional expectations
where the additional terms in Eqs. (5) and (6) cancel when projected on public
information due to symmetry and the law of iterated projections.8 Eqs. (A1) and
(A2) simply state that in expectation, net dealer demand must absorb the demand
from customers. The reason they pin down equilibrium price is that all prices
except the one that satisfies each will generate net excess demand in interdealer
trading, which cannot be reconciled since dealers trade among themselves.
That P1 5 Ls1 s follows directly from Eq. (A1) and the expression for E[Di1 uVT1 ]
from the demand function in Eq. (A12); note that the demand coefficient on c i
equals b11 212dci . In effect, here we postulate this linear demand function, and
prove below that the optimal decision rule does indeed take this form. To see this
implies overshooting, note that equilibrium P1 is such that E[Di1 uVT1 ] has a sign
opposite that of s (i.e., E[Di1 uVT1 ]5 2 lcs s, where lcs is unambiguously positive).
Consider the public information unbiased price P˜ 1 5E[FuVT1 ]5 lFc lcs s. At this
price, E[Di1 uVT1 ]50. Since Di1 is monotonically decreasing in P1 , if s.0 then
P1 .P˜ 1 .0 to induce dealers to go short (ordered relative to 0 because the
unconditional expectation of F is 0); by the same logic, if s,0 then P1 ,P˜ 1 ,0 to
induce dealers to go long.
Similar to P1 , a bias in P2 is necessary to prevent non-zero expected interdealer
trades. To determine E[Di2 uVT2 ] in Eq. (A2), we use normality and exponential
utility to write:
E[Di 2 uVT 2 ] 5 (E[FuVT 2 ] 2 P2 ) /uS2 5 [ lFc ( ls2 s 1 lVV ) 2 P2 ] /uS2 .
Together with the expression for E[c i uVT2 ] at the outset of the appendix, this
implies:
We divide the derivation of trading strategies into three steps. First, we establish
the dealer’s problem as a maximization over a single random variable, the order
flow V. Second, we re-express the problem as a maximization over a random
variable that is independent of a dealer’s own actions, which is necessary since
dealers account for their impact on V. Finally, we solve the maximization problem
established in step two. In order to maintain the clarity of the linear structure of the
problem, we relegate much of the coefficient algebra to a separate appendix
available from the author by request. We also, whenever possible, relegate portions
8
This is clear enough for Eq. (5). For Eq. (6), it is clear once it is recognized that E[2Di1 1T i1 92
E[T 9i1 uVT i1 ]uVT 2 ]5E[c i uVT 2 ], which follows under symmetry from the fact that E[T 9i1 uVT 2 ]5E[Di1 1
9 uVT i1 ]uVT 2 ].
c i 1E[T i1
R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298 293
to the same separate appendix when there are methodological links to previous
work, in particular the appendix of Kim and Verrecchia (1991); though their model
is quite different, their solution techniques are valuable here. Note that Table 1
presents explicit definitions for all coefficients, and Fig. 1 presents the timing of all
random variables.
(A4)
At this juncture, we use can use the moment generating function for the normally
distributed variable F to express the problem as [see Kim and Verrecchia (1991),
pages 316–317]:
which leaves the objective function with two remaining random variables.
Now, an expression for miF is central to the model since this summarizes each
dealer’s end-of-period-one beliefs as a function of each contingency. Making use
once again of the linearity of conditional expectations in our framework, we can
then write:
miF 5 E[FuVTi 2 ] ; fci c i 1 fsi s i 1 fs s 1 fVV (A6)
where values for hfci , fsi , fs , fV j appear in Table 1. This expression summarizes
each dealer’s expectation of F as a function of the non-redundant components of
the information set VTi2 in a manner consistent with PBE in definition 1. Using the
expression for P2 from proposition 2, the dealer’s problem can now be written as a
function of a single random variable V :
2 ]21 S 21 2
2 [pD Di 1 1 pci c i 1 psi s i 1 ps s 1 pV 9V 9] )uVTi 1 ] (A10)
where the constants hgci , gsi , gs , pD , pci , psi , ps , pV9 j are defined in Table 1. This
establishes the problem as a maximization over V 9 – a random variable
independent of own actions.
Max 2
Di 1
E exp [ 2 u(D )(L D i1 V i1 1 gci c i 1 gsi s i 1 gs s 1 LVV 9 2 P1 )
2`
where G;X 21 A21 2 p 2D S 21 2 22uLV . Note that the last two terms in the de-
2
nominator G arise from strategic behavior, traceable to the two D i1 terms in Eq.
2 21
(A11) with coefficients uLV and p D S 2 . This demand function and the fact that
T i1 5Di1 1c i 1dci c i 1dsi s i 1ds s imply:
The period-two trading rule follows directly from Eqs. (6), (A3), (A6):
where the constants h b12 , b22 , b32 , b42 , b52 , b62 j are defined in Table 1.
Proof of Proposition 4
Considering period one first, note from the trading rule in Eq. (A13) that the
coefficient b11 on c i has three components. The first is equal to unity. This
component derives from the undesired inventory generated by customer orders, a
fact that follows from Eqs. (5), (A9) and (A12). This verifies that the period-one
imbalance is passed. Trading rule (R8) insures that the passing is independent if
period-one quotes are common, which they are according to Proposition 1.
Considering now period two, note from the trading rule in Eq. (A14) and from
Table 1 that the coefficient b42 on T 9i1 has two components. The first is equal to
unity. This component derives from the undesired inventory generated by
interdealer trading, which follows from Eqs. (6), (A3), (A6), and the fact that the
other component dT92 comes wholly from the E[T 9i2 uVTi2 ] term in Eq. (6). This
verifies that the period-two imbalance is passed. Trading rule (R8) insures that the
passing is independent if period-two quotes are common, which they are according
to Proposition 2.
296 R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298
Proof of Proposition 5
Period-two prices are a function of the signal in each of the dealer trades T i1
(through V ). Each of these trades has three components: T i1 5Di1 1c i 1E[T 9i1 uc i ,
s i , s, P1 ]. (Though we focus on the Di1 and c i terms, symmetry insures that the
logic holds for the E[T i1 9 uc i , s i , s, P1 ] term.) Under our assumptions (exponential
utility, with risk aversion, second moments, and prices as common knowledge) a
competitive dealer will trade such that Di1 is a sufficient statistic for E[Fuc i , s i , s].
This is most readily apparent from the demand Eq. (A3) in the appendix;
extending this to the first of a two-period problem does not alter the sufficient
statistic property. Using ⇒ to denote sufficiency, we can write D Ci1 5 b C1 c i 1
b C2 s i ⇒E[Fuc i , s i ], where we abstract from public information without loss of
generality. (Superscript C denotes the competitive case.) For a given hc i , s i j, since
D Ci1 ⇒E[Fuc i , s i ], then T Ci1 ⇒E[Fuc i , s i ] only if the ratio of the weights on hc i , s i j in
C C C C C
T i1 equals 5 b 1 /b 2 . Clearly this is not the case: the weight on c i in T i1 is 11 b 1
C
but the weight on s i is b 2 . Hence, backing out the two-dimensional hc i , s i j from
the one-dimensional T i1 is not possible, even though the weights are known. Since
trades are less informative, and trades determine P2 through V, P2 is less
informative.
Proof of Proposition 6
Proof of Proposition 7
First, note that prior to the realization of F E[FuVi ]5 lFc E[cuVi ], where lFc ; SF /
Sc ,1, for any feasible information set Vi since there is never additional
R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298 297
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