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Journal of International Economics 42 (1997) 275–298

A simultaneous trade model of the foreign exchange hot


potato
Richard K. Lyons*
Haas School of Business, U.C. Berkeley, Berkeley CA 94720 -1900, USA
Received 1 November 1992; revised 13 March 1997

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.

Keywords: Microstructure; Information; Externality

JEL classification: G15; F33

‘[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)

*Tel.: (11-510) 642-1059; fax: (11-510) 643-1420; e-mail: lyons@haas.berkeley.edu

0022-1996 / 97 / $17.00  1997 Elsevier Science B.V. All rights reserved


PII S0022-1996( 96 )01471-7
276 R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298

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 show that hot-potato trading is not innocuous. Rather, it produces an


informational inefficiency. This inefficiency arises because the information re-
vealed in price depends on the information in interdealer trades, and the precision
of this information is lowered as a result of hot-potato trading. Price is therefore
less revealing. Consider the following example. There are two dealers, A and B.
The realization of two signals X1 and X2 are observed by A, making A’s
information set hX1 ,X2 j. Suppose that the expectation of the full-information value
F of an asset conditional on hX1 ,X2 j, or E[FuX1 ,X2 ], equals X1 1 X2 . Now suppose
A announces a signal T (for Trade) to B, where T 5 b X1 1 X2 for some non-zero
b, and where b is known by B. Since B knows the weight b, if b 5 1 then T is
sufficient for E[FuX1 ,X2 ]; in contrast, if b ± 1 then T is a noisy signal of
E[FuX1 ,X2 ]. In our model, dealer A’s announcement of T to B corresponds to A’s
trade at B’s quote. All dealers know the weights in the optimal trading rule.
However, hot-potato passing of inventories causes these weights to differ from
weights based on fundamentals alone. This reduces the efficiency of signal
extraction, making trades less informative.
Though information externalities appear in other work on asset pricing, the
mechanism behind them differs from ours [see Grossman (1977); Stein (1987);
Laffont and Maskin (1990)]. In general, these models provide little rationale for
who has private information and who does not. Our model generates asymmetric
information from the institutional structure itself: each dealer has sole knowledge
of his own-customer order flow. To the extent this flow conveys information when
aggregated, it is private information.
A final point concerns the presence of private information in FX markets. Many
consider it absurd to use a specification with private information: unlike equity
markets, everyone in the FX market is utilizing the same public information set.
We disagree. Dealers in particular see partitions of the full information set that
non-dealers do not see (e.g., they see order flow that is not public information).
Even in the extreme case that orders are uncorrelated with long-term fundamentals,
as long as they have transitory impact effects on price (i.e., as long as the FX
market is not infinitely deep), then price-relevant private information at the dealer
level exists. [See Ito et al. (1997).]
The paper is organized as follows: the next section describes key features of FX
trading emphasized in our model; Section 3 introduces the model; Section 4 solves
for equilibrium and presents some implications; and Section 5 concludes. All
proofs are contained in Appendix A, including details of the model’s solution.

2. Features of foreign exchange trading

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.

3. The simultaneous trade model

The model is a two-period game with n dealers, where n is small in a


convergence sense. Each dealer has an equal-sized customer base composed of a
large number of competitive customers (e.g., investors, speculators, corporate
treasurers, liquidity traders, central banks, etc.). All dealers and customers have
identical negative exponential utility defined over nominal wealth at the close of
period two. (Our rationale for focusing on nominal wealth is that consumption
price risk is negligible over periods as short as those we consider here; we return
to the issue of period duration below.) There are two assets, one risk-free and one
risky, the latter representing FX. Returns are realized at the end of period 2, with
the gross return on the riskless asset normalized to one. (Interest rates are in fact
zero intraday.) The risky asset is in zero supply initially, and has full information
value F, where F is independently and normally distributed about 0 with known
variance SF .4 Fig. 1 provides the timing of the model, and introduces notation
developed below.

3.1. Customer orders and information

The following four equations specify the initial information structure:

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

due to substantial lags in aggregate trade statistics). Second, superior information-


processing by certain non-dealer participants may be present. For empirical
validation, there is strong evidence that dealers view order flow as informative in
this market [see Lyons (1995)]. Recall also Feature (1) of the previous section.

3.2. Dealer quoting and trading

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:

T i1 5 Di1 1 c i 1 E[T 9i1 uVT i1 ] (5)

9 2 E[T i19 uVT i1 ] 1 E[T 9i2 uVT i2 ]


T i2 5 Di2 2 Di1 1 T i1 (6)

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).

3.3. The last event each period: more information

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

simpler, more tractable specification. [Adding noise to this equation is analyzed in


Lyons (1996a).]

3.4. Dealer objectives and information sets

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:

Max E[2exp(2u Wi2 uVi )] (8)


P i1 ,P i2
D i1 ,D i2

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 )

where Pi 1 is dealer i’s period-one quote, a 9 denotes a quote or trade received by


dealer i, and F is the full-information value of the risky asset at the end of period
two. The last two terms in final wealth capture the undesired position disturbances.
The conditioning information Vi at each decision node (2 quotes and 2 trades) is
summarized in Fig. 1.

4. Equilibrium and implications

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:

(i) Bayes rule is used to update beliefs and


(ii) Quoting and trading strategies are sequentially rational given beliefs.

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),

EhUi (P,T )uVij $ EhUi (P,T


ˆ ˆ )uVij ;i (9)
R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298 285

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

4.1. Equilibrium quoting strategies

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 .

Proposition 1: A quoting strategy is consistent with symmetric PBE only if the


period-one quote is common across dealers; further, the common quote:
P1 5 Ls1 s

necessarily overshoots the public-information unbiased price of lFc lcs s.

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:

Proposition 2: A quoting strategy is consistent with symmetric PBE only if the


common period-two quoted price is:
P2 5 Ls2 s 1 LVV.

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 )]

P1 , P2 is pinned down by public information since common quotes cannot be


based on information that is not common. The public information available in
period two includes the order-flow statistic V in addition to s. The private
R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298 287

information not reflected in P2 becomes the basis for speculative dealer demands
in period two.

4.2. Equilibrium trading strategies

Given the quoting strategy described in propositions 1 and 2, the following


proposition defines an optimal trading strategy corresponding to symmetric linear
equilibrium:

Proposition 3: The trading strategy profile:


T i1 5 b11 c i 1 b21 s i 1 b31 s 2 b41 P1

9 1 b52V 2 b62 P2
T i2 5 b12 c i 1 b22 s i 1 b32 s 1 b42 T i1

;i[h1, . . . ,nj, is a perfect Bayesian equilibrium per definition 1.

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.

4.3. Hot-potato trading

The following proposition introduces the sense in which our equilibrium


exhibits the so-called hot-potato property referred to in the literature: 6

Proposition 4: Trading has a hot-potato property in the sense that inventory


imbalances are passed from dealer to dealer, and this occurs independently of
whether they offset the imbalance of the receiving dealer.

This hot-potato property of equilibrium arises because arbitrage limits


idiosyncratic dispersion in price. Without dispersion in price, trading dealers are
not paired such that their imbalances offset. This property is in sharp contrast to
standard rational expectations trading models [e.g., Grundy and McNichols
(1989); Kim and Verrecchia (1991)]. In the standard models, inventory imbalances

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

are impossible at the close of trading since agents condition on market-clearing


prices. We view these imbalances as an important dimension of any model that
addresses trading in FX. By producing hot-potato trading in equilibrium, our
model provides a rationale for the skeptic who asks Why doesn’t price simply
adjust? In our equilibrium, price does adjust, but can accommodate only average
imbalances; idiosyncratic imbalances remain because arbitrage limits idiosyncratic
dispersion in price.

4.4. The informativeness of price

The following proposition establishes that the hot-potato passing of inventories


is not innocuous. Rather, it hampers information aggregation. This occurs because
the passing of inventories dilutes the information content of order flow. To isolate
this effect, we abstract from the role of strategic behavior until proposition 6.

Proposition 5: Hot-potato trading reduces the information content of period-two


price, even if dealers behave competitively.

This result, discussed further following proposition 6, is rather intuitive.


Information aggregation occurs through signal extraction applied to order flow.
The greater the noise relative to signal, the less effective the signal extraction. The
passing of hot-potato liquidity trades increases the noise in order flow.
The following proposition addresses the incremental effect of strategic dealer
behavior on the degree to which period-two price reveals information.

Proposition 6: Strategic dealer behavior reduces the information in period-two


price.

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

reducing the informational efficiency of price. Third, hot-potato trading is


consistent with equilibrium in an optimizing model. Though authors have
attributed the extraordinary volume in FX to the repeated passing of undesired
inventories, this process has never been modeled in the context of rational agents.
In our view the model is a distinct approach to trading. A key departure from
rational expectations models, for example, is that we do not assume dealers can
condition on market-clearing prices. Transactions play an integral part in the
updating of expectations and eventual price determination. This role for transac-
tions generates clear links between information asymmetry, volume, and price
adjustment. These links can be simulated on the basis of the seven parameters in
the first row of Table 1. Thus, the model provides a vehicle for analyzing
interesting variations in information structure and market configuration.

Acknowledgments

Previous titles include ‘Information Externalities in the Microstructure of the


Foreign Exchange Market’ and ‘Private Beliefs and Information Externalities in
the Foreign Exchange Market.’ I thank the following for helpful comments: two
anonymous referees, Ricardo Caballero, Henry Cao, Bob Cumby, Mark Flood,
Alberto Giovannini, Charles Goodhart, Ananth Madhavan, and seminar particip-
ants at Berkeley, Chicago, Columbia, MIT, Montreal, NYU, Penn, Princeton,
Stanford, Wharton, and the NBER Summer Institute. I owe special thanks to one of
the referees for improving the paper substantially. I also thank Jeff Bohn and E.
Meng Tan for fine research assistance, and Merrill Lynch and Lasser Marshall for
access to dealers and brokers while trading. Financial assistance from the National
Science Foundation and the Berkeley Program in Finance is gratefully acknowl-
edged. Any errors are mine.

Appendix A

This appendix uses certain information sets and conditional expectations


repeatedly. To simplify notation, we present these at the outset for reference.

Information sets

VTi 1 ;hc i ,si ,s, i 51nhPi 1jj

VTi 2 ;hc i ,si ,s, i 51nhPi 1j,T i 1 ,T 9i 1 ,V, i 51nhPi 2jj

VT 1 ;hs, i 51nhPi 1jj


R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298 291

VT 2 ;hs, i 51nhPi 1j,V, i 51nhPi 2jj


The first two are the private information sets available at the time of trading in
each of the two periods (defined in the text). The second two are the public
information sets available at the time of trading in each of the two periods.

Conditional expectations

E[FuVT 1 ] 5 lFc E[cuVT 1 ] 5 lFc lcs s

E[c i uVT 1 ] 5 E[s i uVT 1 ] 5 E[cuVT 1 ] 5 lcs s

E[FuVT 2 ] 5 lFc E[cuVT 2 ] 5 ls 2 s 1 lVV

E[c i uVT 2 ] 5 lcis s 1 lciVV


where the l’s are signal extraction coefficients defined in Table 1.
Though the above expressions highlight conditional means, the propositions also
involve conditional variances, and these deserve comment. The key point is that,
under our normality assumptions, conditional variances do not depend on
conditioning variables’ realizations. For example, if S2 ;Var[FuVTi2 ], this con-
ditional variance does not depend on dealer i’s particular realization of c i and s i in
VTi2 . This implies that S2 is common to all dealers, and known in period one.
(Indeed, it is a convenient property of the normal distribution that realizations of
conditioning variables affect the conditional mean, but not the precision of the
condition mean.) This predetermination of period two conditional variances is
essential to the period–one quoting and trading rules.

Proof of propositions 1 and 2: price determination

Rational quotes must be common to avoid arbitrage given quoting rules


(R1)–(R5), and trading rules (R6)–(R7). With common prices, the level necessari-
ly depends only on commonly observed information. (Prices are thus never
relevant as conditioning variables since they depend deterministically on common-
ly observed variables already in the information sets.) Accordingly, the equations
that pin down the equilibrium price in each period are necessarily conditioned on
public information.
The equations that pin down equilibrium price are Eqs. (5) and (6), the dealer
trading rules in each period. Per above, when conditioned on public information
they must be consistent with equilibrium price. This implies the following key
relations:
E[Di 1 uVT 1 ] 1 E[c i uVT 1 ] 5 0 (A1)
292 R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298

E[Di 2 uVT 2 ] 1 E[c i uVT 2 ] 5 0 (A2)

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:

P2 5 (uS2 lcis 1 lFc ls 2 )s 1 (uS2 lciV 1 lFc lV )V ; Ls 2 s 1 LVV

Proof of Proposition 3: optimal trading strategies

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.

Step one: Maximization over the random variable V


The dynamic programming problem requires that we first determine the period
two desired position for use in the period-one first order condition. Under
normality and negative exponential utility it is well known that the period two
desired position is:
Di 2 5 ( miF 2 P2 )(uS2 )21 (A3)
[see O’Hara (1995) pages 156–158] where miF ;E[FuVTi2 ], u is the coefficient of
absolute risk aversion, and S2 denotes Var[FuVTi2 ]. Omitting terms unrelated to
Di1 , we can write the dealers’ problem as:

Max EP 2 , miF ,Ff 2 exps 2 u Di 1 (P2 2 P1 ) 2 ( miF 2 P2 ) S 21


2 (F 2 P2 )duVTi 1g.
Di 1

(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]:

Max EP 2 , miFf 2 exps 2 u Di 1 (P2 2 P1 ) 2 ]12 ( miF 2 P2 )2 S 21


2 duVTi 1g (A5)
Di 1

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 :

Max EVf 2 exps 2 u Di 1 (Ls 2 s 1 LVV 2 P1 ) 2 ]12 S 21


2 [fci c i 1 fsi s i
Di 1

1 (fs 2 Ls 2 )s 1 (fV 2 LV )V ] 2duVTi 1g. (A7)


294 R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298

Step two: Accounting for dealer i’ s impact on V


Given that dealer i considers the effect of her own order on V, it would not be
appropriate to take the expectation over V. It is necessary to define a new variable
on which dealer i has no effect, V 9, which is the interdealer order flow netted of
dealer i’s trade:
V 9 ;V 2 T i 1 . (A8)
From Eq. (5), we know that:
T i 1 5 Di 1 1 c i 1 E[T 9i 1 uVTi 1 ]. (59)
Making use once again of the linearity of conditional expectations, for the last
term we can write:
E[T 9i 1 uVTi 1 ] ; dci c i 1 dsi s i 1 ds s (A9)
where the constants hdci , dsi ,ds j are defined in Table 1. Making this substitution for
T i1 , the objective function in Eq. (A7) becomes:

Max EV 9 [ 2 exp( 2 u (Di 1 )(LV Di 1 1 gci c i 1 gsi s i 1 gs s 1 LVV 9 2 P1 )


Di 1

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.

Step three: Solving the maximization problem


To express the expectation in Eq. (A10) in terms of an integral, we use the fact
that V 9 is normally distributed. Let SV9 and mV9 denote Var[V 9uVTi1 ] and
E[V 9uVTi1 ]. The following objective function is proportional to that in Eq. (A10):
`

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`

2 ]21 S 221 [pD Di 1 1 pci ci 1 psi si 1 ps s 1 pV 9V 9] 2 2 ]21 S V219 (V 9 2 mV 9 )2 ] dV 9


(A11)
Here, we draw on a solution technique from Kim and Verrecchia (1991), pages
317–319. With this technique, it is straightforward to show that the resulting first
order condition is:
[X 21 A21 2 p D2 S 221 2 2uLV ]Di 1 2 [ugci 1 pD pci S 221 2 X1 X2 A21 ]c i
2 [ugsi 1 pD psi S 21
2 2 X1 X3 A
21
]s i 2 [ugs 1 pD ps S 221 2 X1 X4 A21 ]s 1 u P1
50
R.K. Lyons / Journal of International Economics 42 (1997) 275 – 298 295

where the constants hX1 , X2 , X3 , X4 j are defined in Table 1. Collecting terms


yields:

Di 1 5f(ugci 1 pD pci S 21 ) /Ggc i


21
2 2 X1 X2 A

1f(ugsi 1 pD psi S 221 2 X1 X3 A21 ) /Ggs i


1f(ugs 1 pD ps S 2 2 X1 X4 A ) /Ggs 2fu /GgP1
21 21
(A12)

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:

T i 1 5f1 1 dci 1 (ugci 1 pD pci S 221 2 X1 X2 A21 ) /Ggc i


1fdsi 1 (ugsi 1 pD psi 2 S 2 2 X1 X3 A ) /Ggs i
21 21

1fds 1 (ugs 1 pD ps S 2 2 X1 X4 A ) /Ggs 2fu /GgP1


21 21

; b11 c i 1 b21 s i 1 b31 s 2 b41 P1 (A13)

The period-two trading rule follows directly from Eqs. (6), (A3), (A6):

T i 2 5 Di 2 2 Di 1 1 T i91 2 E[T i91 uVTi 1 ] 1 E[T i92 uVTi 2 ]


; b12 c i 1 b22 s i 1 b32 s 1 b42 T 9i 1 1 b52V 2 b62 P2 (A14)

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

From the proof of proposition 5, we can write D Ci1 5 b C1 c i 1 b C2 s i ⇒E[Fuc i , s i ].


Considering now the strategic case – denoted with superscript S – we have
D Si1 5 b S1 c i 1 b 2S s i . For a given hc i , s i j, since D Ci1 ⇒E[Fuc i , s i ], then D Si1 ⇒E[Fuc i , s i ]
S S C C S S C C
only if b 1 /b 2 5 b 1 /b 2 . But in fact, b 1 /b 2 . b 1 /b 2 . To see that the effect of
strategic behavior on the weights is not equiproportional, consider the coefficients
on c i and s i in the demand Eq. (A12) in the appendix: first, note from Table 1 that
gci 5 LV (11dci ) whereas gsi 5 LVdsi ; second, note that LV , dci , and dsi are
unambiguously positive; third, note that the 1 in gci derives from the c i term that
enters T i1 directly; finally, the last two terms in the numerators of the coefficients
on c i and s i are functions of p coefficients, and therefore arise due to the impact
on opportunities in the second period; it is straightforward to show that these do
not offset the effect of strategic behavior on the g ’s demonstrated above. This
incremental effect on b S1 – coupled with the fact that a competitive T i1 already
overweights c i per proposition 5 – implies that strategic behavior reduces the
information in dealer trades, which reduces the information in P2 .

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

information for extracting F from c. Hence, changes in Var[FuVi ] are proportional


to changes in Var[cuVi ];Vi . Now, it is straightforward to show that E[cuc i ,
s i ]5 b c 1 b2 s i where b1 ; S x21 /(S c21 1 S x21 1 S j21 )21 and b2 ; S j21 /(S c21 1
21 1 i21 21
S x 1 S j ) , and where x i and j i are the noise terms in the signals c i and s i
from Eq. (1) and Eq. (2), respectively. Let T i1 5 kb1 c i 1 b2 s i for some k .1. We
need to show that Var[cuT i1 , b1 , b2 , k ] is increasing in k. It is straightforward to
show that Var[cuc i , s i ]5(S c21 1 S x21 1 S 21
j )
21
. It is also straightforward to show
21 21 21
that Var[cuT i1 , b1 , b2 , k ]5(S F 1 S v ) where v ;(kb1 x i 1 b2 j i ) /(kb1 1 b2 ).
Hence, Sv 5[kb1 /(kb1 1 b2 )] 2 Sx 1[ b2 /(kb1 1 b2 )] 2 Sj . It is therefore sufficient to
show that dSv / dk .0. Using (i) the definitions of b1 and b2 and (ii) the fact that
both b1 and b2 are positive, it is straightforward to show that the sign of dSv / dk
is the same as the sign of (k 21)Var[cuc i , s i ], which is unambiguously positive
since k .1.

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