An Information Approach to International Currencies, Issue 11220
National Bureau of Economic Research, 2005 - Foreign exchange rates - 26 pages
This paper addresses currency competition from an information perspective. Transactions in traditional models do not convey information, so transaction costs -- the driver of competition outcomes -- are driven by market size. In our model transactions do convey information (consistent with recent empirical findings). Several important departures arise. First, adding the information dimension resolves the traditional indeterminacy of currency trade patterns (by mitigating the concentrating force of market-size economies). Second, whether transactions are executed directly or through a vehicle actually affects prices (because these trading methods do not in general reveal the same information). Third, our model provides a new rationale for why some currency pairs never trade directly (information is not sufficiently symmetric to support trading). Fourth, our model formalizes the arbitrage process and shows that arbitrage transaction quantities and price levels are jointly determined. Empirically, the paper provides a first integrated analysis of transactions in a triangle of markets: yen/$, $/Euro, and yen/Euro. Data for the full triangle permits comparison of direct, indirect and arbitrage transactions, for each pair. The information model predicts that transactions should affect prices across markets (e.g., flow in the yen/$ market should convey information relevant to $/Euro and yen/Euro prices), which is borne out
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affect prices Approach to International arbitrage trading banks basis points coefficients cross-market currency exchange patterns currency pairs currency triangle Daron Acemoglu denote a sale empirical analysis equation 12 equilibrium euro/yen example exchange rate Financial Economics flow in market foreign exchange market fundamental value Glosten Hartmann hedge funds indirect trade indirectly information approach information asymmetry information dimension information model informed traders inside the back International Money Journal of Finance Journal of International Killeen Krugman Kyle model liquidity trades Lyons market e.g. market-size approach market-size economies matrix measured Milgrom Money and Finance Moore NBER Working Paper papers in hard patterns of currency price impact purchase real trade relative vehicleness sale in market three markets trade directly trader in market trading volume transaction costs transaction flows transactions are executed triangular arbitrage triangular parity two-way arbitrage U.S. dollar value innovations variance vehicle currency vehicle role yen per euro zero