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Abstract:
International mutual funds are key contributors to the globalization of financial markets and one of the main sources of capital flows to emerging economies. Despite their importance in emerging markets, little is known about their investment allocation and strategies. This paper provides an overview of mutual fund activity in emerging markets. First, we describe their relative size, asset allocation, and country allocation. Second, we focus on funds' behavior during emerging markets crises in the 1990s, analyzing data at both the fund-manager and fund-investor levels. Due to large redemptions and injections, funds' flows are not stable. Withdrawals from emerging markets during recent crises were large, which is consistent with existing evidence of financial contagion.

mutual funds, emerging markets, capital flows, equity investment, contagion, crises

Abstract:
How do mutual funds behave when they invest in emerging economies? For one thing, mutual funds' flows are not stable. Withdrawals from emerging markets during recent crises were large, which squares with existing evidence of financial contagion.

International mutual funds are one of the main channels for capital flows to emerging economies. Although mutual funds have become important contributors to financial market integration, little is known about their investment allocation and strategies. Kaminsky, Lyons, and Schmukler provide an overview of mutual fund activity in emerging markets.

First, they describe international mutual funds' relative size, asset allocation, and country allocation.

Second, they focus on fund behavior during crises, by analyzing data at the level of both investors and fund managers.

Among their findings: Equity investment in emerging markets has grown rapidly in the 1990s, much of it flowing through mutual funds. Collectively, these funds hold a sizable share of market capitalization in emerging economies. Asian and Latin American funds achieved the fastest growth, but are smaller than domestic U.S. funds and world funds.

When investing abroad, U.S. mutual funds invest more in equity than in bonds. World funds invest mainly in developed nations (Canada, Europe, Japan, and the United States). Ten percent of their investment is in Asia and Latin America. Mutual funds usually invest in a few countries within each region.

Mutual fund investment was very responsive to the crises of the 1990s. Withdrawals from emerging markets during recent crises were large, which squares with existing evidence of financial contagion.

Investments in Asian and Latin American mutual funds are volatile. Because redemptions and injections are large relative to total funds under management, funds' flows are not stable. The cash held by managers during injections and redemptions does not fluctuate significantly, so investors' actions are typically reflected in emerging market inflows and outflows.

This paper - a product of Macroeconomics and Growth, Development Research Group - is part of a larger effort in the group to understand the operation of financial markets and the effects of financial globalization. The study was funded by the Bank's Research Support Budget under the research project "Mutual Funds in Emerging Markets." The authors may be contacted at graciela@gwu.edu, lyons@haas.
berkeley.edu, or sschmukler@worldbank.org.

Abstract:
Macroeconomic models of nominal exchange rates perform poorly. The propor-tion of monthly exchange rate changes that these models can explain is essen-tially zero. This paper presents a model of a new kind. Instead of relying exclu-sively on macroeconomic determinants, the model includes a determinant from the field of microstructure?order flow. Order flow is the proximate determinant of price in all microstructure models. This is a radically different approach to ex-change rate determination. It is also strikingly successful in accounting for real-ized rates. Our model of daily changes in log exchange rates produces R 2 statis-tics above 60 percent. For the DM/$ spot market, we find that $1 billion of net dollar purchases increases the DM price of a dollar by about 0.5 percent.

Abstract:
We examine the trading strategies of mutual funds in emerging markets. We develop a method for disentangling the behavior of fund managers from that of underlying investors. For both managers and investors, we strongly reject the null hypothesis of no momentum trading: mutual funds systematically sell losers and buy winners. Selling current losers and buying current winners is stronger during crises, and equally strong for managers and investors. Selling past losers and buying past winners is stronger for managers. Managers and investors also practice contagion trading - they sell (buy) assets from one country when asset prices fall (rise) in another.

Mutual funds, managers, investors, trading strategies, emerging markets, momentum, feedback trading, crisis, contagion

Abstract:
This paper addresses the trading strategies of mutual funds in emerging markets. The data set we develop permits analysis of these strategies at the level of individual portfolios. Methodoloically, a novel feature is our disentangling the behavior of managers from that of underlying investors. For both managers and investors, we strongly reject the null hypothesis of no momentum trading: funds' momentum trading is positive they systematically buy winners and sell losers. Contemporaneous momentum trading (buying current winners and selling current losers) is stronger during crises, and stronger for fund investors than for fund managers. Lagged momentum trading (buying past winners and selling past losers) is stronger during non-crisis, and stronger for fund managers. Investors also engage in contagion trading, i.e., they sell assets from one country when asset prices fall in another.

Abstract:
This study of an important class of investors-U.S. mutual funds-finds that mutual funds do engage in momentum trading (buying winners and selling losers). They also engage in contagion trading strategies (selling assets from one country when asset prices fall in another).

Kaminsky, Lyons, and Schmukler address the trading strategies of mutual funds in emerging markets. The data set they develop permits analyses of these strategies at the level of individual portfolios.

A methodologically novel feature of their analysis: they disentangle the behavior of fund managers from that of investors.

For both managers and investors, they strongly reject the null hypothesis of no momentum trading. Funds' momentum trading is positive: they systematically buy winners and sell losers.

Contemporaneous momentum trading (buying current winners and selling current losers) is stronger during crises, and stronger for fund investors than for fund managers.

Lagged momentum trading (buying past winners and selling past losers) is stronger during noncrises, and stronger for fund managers.

Investors also engage in contagion trading-selling assets from one country when asset prices fall in another.

These findings are based on data about mutual funds that represent only 10 percent of the market capitalization in the countries considered. Were it a larger share of the market, finding counterparties for their trades (the investors who buy when they sell and sell when they buy) would be difficult-and the premise that funds respond to contemporaneous returns rather than causing them would become tenuous.

This paper - a product of Macroeconomics and Growth, Development Research Group - is part of a larger effort in the group to understand capital flows to developing countries. The study was funded by the Bank`s Research Support Budget under the research project "Mutual Fund Investment in Developing Countries." The authors may be contacted at graciela@gwu.edu, lyons@haas.berkeley.edu, or sschmukler@worldbank.org.

Abstract:
This paper compares the true, ex-ante forecasting performance of a micro-based model against both a standard macro model and a random walk. In contrast to existing literature, which is focused on longer horizon forecasting, we examine forecasting over horizons from one day to one month (the one-month horizon being where micro and macro analysis begin to overlap). Over our 3-year forecasting sample, we find that the micro-based model consistently out-performs both the random walk and the macro model. Micro-based forecasts account for almost 16 per cent of the sample variance in monthly spot rate changes. These results provide a level of empirical validation as yet unattained by other models. Our result that the micro-based model out-performs the macro model does not imply that macro fundamentals will never explain exchange rates. Quite the contrary, our findings are in fact consistent with the view that the principal driver of exchange rates is standard macro fundamentals. In Evans and Lyons (2004b) we report firm evidence that the non-public information that we exploit here for forecasting exchange rates is also useful for forecasting macro fundamentals themselves.

Abstract:
This paper compares the true, ex-ante forecasting performance of a micro-based model against both a standard macro model and a random walk. In contrast to existing literature, which is focused on longer horizon forecasting, we examine forecasting over horizons from one day to one month (the one-month horizon being where micro and macro analysis begin to overlap). Over our 3-year forecasting sample, we find that the micro-based model consistently out-performs both the random walk and the macro model. Micro-based forecasts account for almost 16 per cent of the sample variance in monthly spot rate changes. These results provide a level of empirical validation as yet unattained by other models. Though our micro-based model out-performs the macro model, this does not imply that past macro analysis has overlooked key fundamentals: our structural interpretation using a fundamentals-based model shows that our findings are consistent with exchange rates being driven by standard fundamentals.

Exchange rates, forecasting, Meese and Rogoff, microstructure, order flow

Abstract:
We address the exchange rate determination puzzle by examining how information is aggregated in a dynamic general equilibrium (DGE) setting. Unlike other DGE macro models, which enrich either preference structures or production structures, our model enriches the information structure. The model departs from microstructure-style modeling by identifying the real activities where dispersed information originates, as well as the technology by which information is subsequently aggregated and impounded. Results relevant to the determination puzzle include: (1) persistent gaps between exchange rates and macro fundamentals, (2) excess volatility relative to macro fundamentals, (3) exchange rate movements without macro news, (4) little or no exchange rate movement when macro news occurs, and (5) a structural-economic rationale for why transaction flows perform well in accounting for monthly exchange rate changes, whereas macro variables perform poorly. Though past micro analysis has made progress on results (1) through (3), results (4) and (5) are new. Excess volatility arises in our model for a new reason: rational exchange rate errors feed back into the fundamentals that the exchange rate is trying to track.

Abstract:
We address the exchange rate determination puzzle by examining how information is aggregated in a dynamic general equilibrium (DGE) setting. Unlike other DGE macro models, which enrich either preference structures or production structures, our model enriches the information structure. The model departs from microstructure-style modeling by identifying the real activities where dispersed information originates, as well as the technology by which information is subsequently aggregated and impounded. Results relevant to the determination puzzle include: (1) persistent gaps between exchange rates and macro fundamentals, (2) excess volatility relative to macro fundamentals, (3) exchange rate movements without macro news, (4) little or no exchange rate movement when macro news occurs, and (5) a structural-economic rationale for why transaction flows perform well in accounting for monthly exchange rate changes, whereas macro variables perform poorly. Though past micro analysis has made progress on results (1) through (3), results (4) and (5) are new. Excess volatility arises in our model for a new reason: rational exchange rate errors feed back into the fundamentals that the exchange rate is trying to track.

Exchange rates, dispersed information, general equilibrium, microstructure

Abstract:
This paper addresses whether macro news arrivals affect currency markets over time. The null from macro exchange-rate theory is that they do not: macro news is impounded in exchange rates instantaneously. We test this by examining the effects of news on subsequent trades by end-user participants (such as hedge funds, mutual funds, and non-financial corporations). News arrivals induce subsequent changes in trading in all of the major end-user segments. These induced changes remain significant for days. Induced trades also have persistent effects on prices. Currency markets are not responding to news instantaneously.

Abstract:
This paper addresses whether macro news arrivals affect currency markets over time. The null from macro exchange-rate theory is that they do not: macro news is impounded in exchange rates instantaneously. We test this by examining the effects of news on subsequent trades by end-user participants (such as hedge funds, mutual funds, and non-financial corporations). News arrivals induce subsequent changes in trading in all of the major end-user segments. These induced changes remain significant for days. Induced trades also have persistent effects on prices. Currency markets are not responding to news instantaneously.

exchange rates, news, macroeconomic announcements

Abstract:
This paper tests the portfolio-balance approach to exchange rate determination in a new way. Past work on portfolio balance in foreign exchange falls into two groups: (1) tests using measures of asset supply and (2) tests using measures of central-bank asset demand. We address the demand side, but we use a broad measure of public demand, rather than focusing on demand by central banks. Under floating rates, changing public demand has no direct effect on interest rates, current or future. This provides an opportunity to test for portfolio-balance effects on price. We develop and estimate a micro portfolio-balance model that has both Walrasian and microstructure features. Portfolio-balance effects are clearly present: the immediate price impact of public trades is 0.44 percent per $1 billion (of which, about 80 percent persists indefinitely). This estimate is applicable to central-bank trades as well, as long as they are sterilized, secret, and provide no monetary-policy signal. Intervention of this type is most effective when the flow of macroeconomic news is strong.

Abstract:
This paper tests the portfolio-balance approach to exchange rate determination in a new way. Past work on portfolio balance in foreign exchange falls into two groups: (1) tests using measures of asset supply and (2) tests using measures of central-bank asset demand. We address the demand side, but we use a broad measure of public demand, rather than focusing on demand by central banks. Under floating rates, changing public demand has no direct effect on interest rates, current or future. This provides an opportunity to test for portfolio-balance effects on price. We develop and estimate a micro portfolio-balance model that has both Walrasian and microstructure features. Portfolio-balance effects are clearly present: the immediate price impact of public trades is 0.44 percent per $1 billion (of which, about 80 percent persists indefinitely). This estimate is applicable to central-bank trades as well, as long as they are sterilized, secret, and provide no monetary-policy signal. Intervention of this type is most effective when the flow of macroeconomic news is strong.

Exchange rates, portfolio balance models, microstructure, intervention

Abstract:
This paper examines trading costs in markets where dealers search for price quotes (such as multiple-dealer equity markets and foreign exchange). Using an experimental market, we compare four popular models for estimating effective spreads. The theoretical implications of 'bid-ask bounce' are borne out with remarkable accuracy in the time series of transaction prices. More important, the cost of bilateral price search is a significant component of the effective spread (roughly 40 percent using the Roll (1984) measure). These search costs are a distinct component of the spread that has not been considered in the literature.

Abstract:
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/Euro market should convey information relevant to $/Euro and Yen/Euro prices), which is borne out.

Abstract:
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/$, $/Euro, and Yen/Euro. Data for the full triangle permits comparison of direct, indirect and arbitrage transactions, for each pair. The information model makes the important prediction that transactions should affect prices across markets (e.g., flow in the Yen/$ market should convey information relevant to $/Euro and Yen/Euro prices), which is borne out.

Foreign exchange, vehicle currency, information, microstructure

Abstract:
This paper provides a new test for whether different-currency assets are imperfect substitutes. The test exploits the fact that under floating rates, changing public currency demand has no direct effect on monetary fundamentals, current or future. Price effects from imperfect substitutability are clearly present: the immediate price impact of public trades is 0.44 percent per 1 billion dollar (of which about 80 percent persists indefinitely). This estimate is applicable to intervention trades in the special case when they are indistinguishable from private trades (i.e., when interventions are sterilized, anonymous, and provide no monetary-policy signal).

Abstract:
This paper develops a model for understanding end-user order flow in the FX market. The model addresses several puzzling findings. First, the estimated price-impact of flow from different end-user segments is, dollar-for-dollar, quite different. Second, order flow from segments traditionally thought to be liquidity-motivated actually has power to forecast exchange rates. Third, about one third of order flow's power to forecast exchange rates one month ahead comes from flow's ability to forecast future flow, whereas the remaining two-thirds applies to price components unrelated to future flow. We show that all of these features arise naturally from end-user heterogeneity, in a setting where order flow provides timely information to market-makers about the state of the macroeconomy.

Abstract:
We address whether transaction flows in foreign exchange markets convey fundamental information. Our GE model includes fundamental information that first manifests at the micro level and is not symmetrically observed by all agents. This produces foreign exchange transactions that play a central role in information aggregation, providing testable links between transaction flows, exchange rates, and future fundamentals. We test these links using data on all end-user currency trades received at Citibank over 6.5 years, a sample sufficiently long to analyze real-time forecasts at the quarterly horizon. The predictions are borne out in four empirical findings that define this paper's main contribution: (1) transaction flows forecast future macro variables such as output growth, money growth, and inflation, (2) transaction flows forecast these macro variables significantly better than the exchange rate does, (3) transaction flows (proprietary) forecast future exchange rates, and (4) the forecasted part of fundamentals is better at explaining exchange rates than standard measured fundamentals.

Abstract:
This paper introduces a three-part transactions dataset to test various microstructural hypotheses about the spot foreign exchange market. In particular, we test for effects of trading volume on quoted prices through the two channels stressed in the literature: the information channel and the inventory-control channel. We find that trades have both a strong information effect and a strong inventory-control effect, providing support for both strands of microstructure theory. The bulk of equity-market studies also find an information effect; however, these studies typically interpret this as evidence of inside information. Since there are no insiders in the foreign exchange market, this finding suggests a broader conception of the information environment, at least in this context.

Abstract:
This paper introduces a transactions dataset to test microstructural hypotheses in the spot foreign exchange market. The dataset reflects all the trading activity of a dealer whose average daily volume is over $1 billion over the five-day sample. We use the data to test for effects of trading volume on prices through the two channels stressed in the literature: the information channel and the inventory-control channel. We find that trades have both a strong information effect and a strong inventory-control effect, providing support for both branches of microstructure theory. The strong inventory-control effect arises despite the fact that foreign exchange dealers have an additional means of inventory control that a specialist does not, namely trading on another dealer's prices.

Abstract:
This paper tests whether macroeconomic news is transmitted to exchange rates via the transactions process and if so, what share occurs via transactions versus the traditional direct channel. We identify the link between order flow and macro news using a heteroskedasticity-based approach, a la Rigobon and Sack (2002). In both daily and intra-daily data, order flow varies considerably with macro news flow. At least half of the effect of macro news on exchange rates is transmitted via order flow.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
This paper examines whether currency trading volume is informative, and under what circumstances. Specifically, we use transactions data to test whether trades occurring when trading intensity is high are more informative - dollar for dollar - than trades occurring when intensity is low. Theory admits both possibilities, depending primarily on the posited information structure. We present what we call a hot-potato model of currency trading, which explains why low-intensity trades might be more informative. In the model, the wave of inventory-management trading among dealers following innovations in order flow generates an inverse relationship between intensity and information content. Empirically, low-intensity trades are more informative, supporting the hot-potato hypothesis."

Abstract:
In a market with symmetric information about fundamentals, can information-based trade still arise? Consider bond and FX markets, where private information about nominal cash flows is generally absent, but participants are convinced that superior information exists. We analyze a class of asymmetric information - inventory information - that is unrelated to fundamentals, but still forecasts future price (by forecasting future discount factors). Empirical work based on the analysis shows that inventory information in FX does indeed forecast discount factors, and does so over both short and long horizons. The immediate price impact of shocks to inventory information is large, roughly 50 percent of that from public information shocks (the latter being the whole story under symmetric information). Within about 30 minutes the transitory effect dies out, and prices reflect a permanent effect from inventory information that ranges between 15 and 30 percent of that from public information.

Abstract:
This paper presents an exchange rate model of a new kind. Instead of relying exclusively on macroeconomic determinants, the model includes a determinant from the field of microstructure finance - order flow. Order flow is a determinant because it conveys information. This is a radically different approach to exchange rates. It is also strikingly successful. Our model of daily deutsche mark/dollar log changes produces an R2 statistic above 60 percent. For the deutsche mark/dollar spot market as a whole, we find that $1 billion of net dollar purchases increases the deutsche mark price of a dollar by 0.5 percent.

Abstract:
Macroeconomic models of nominal exchange rates perform poorly. In sample, R2 statistics as high as 10 percent are rare. Out of sample, these models are typically out-forecast by a naive random walk. This paper presents a model of a new kind. Instead of relying exclusively on macroeconomic determinants, the model includes a determinant from the field of microstructure-order flow. Order flow is the proximate determinant of price in all microstructure models. This is a radically different approach to exchange rate determination. It is also strikingly successful in accounting for realized rates. Our model of daily exchange-rate changes produces R2 statistics above 50 percent. Out of sample, our model produces significantly better short-horizon forecasts than a random walk. For the DM/$ spot market as a whole, we find that $1 billion of net dollar purchases increases the DM price of a dollar by about 1 pfennig.

Abstract:
Intraday interest rates are zero. Consequently, a foreign exchange dealer can short a vulnerable currency in the morning, close this position in the afternoon, and never face an interest cost. This tactic might seem especially attractive in times of crisis, since it suggests an immunity to the central bank's interest rate defense. In equilibrium, however, buyers of the vulnerable currency must be compensated on average with an intraday capital gain as long as no devaluation occurs. That is, currencies under attack should typically appreciate intraday. Using data on intraday exchange rate changes within the EMS, we find this prediction is borne out.

Abstract:
An information externality exists in the foreign exchange market due to the fact that traders play two partially conflicting roles: (i) each is a speculator and (ii) each is an information clearinghouse in that each intermediates own-customer orders which convey information. Profit maximization induces traders to underweight fundamental information in making their trades, reducing the degree to which prices reveal information at any given time. In the model, agents update diverse beliefs over time, with transactions-mediated tatonnement. The explicit role for transactions provides a framework for interpreting the relationship between the diversity of beliefs, trading volume, and price adjustment.

Abstract:
This paper addresses the puzzle of regime-dependent volatility in foreign exchange. We extend the literature in two ways. First, our microstructural model provides a qualitatively new explanation for the puzzle. Second, we test implications of our model using Europe's recent shift to rigidly fixed rates (EMS to EMU). In the model, shocks to order flow induce volatility under flexible rates because they have portfolio-balance effects on price, whereas under fixed rates the same shocks do not have portfolio-balance effects. These effects arise in one regime and not the other because the elasticity of speculative demand for foreign exchange is (endogenously) regime-dependent: low elasticity under flexible rates magnifies portfolio-balance effects; under credibly fixed rates, elasticity of speculative demand is infinite, eliminating portfolio-balance effects. New data on FF/DM transactions show that order flow had persistent effects on the exchange rate before EMU parities were announced. After announcement, determination of the FF/DM rate was decoupled from order flow, as predicted by the model.

Abstract:
No abstract is available for this paper.

Abstract:
It is a common view that private information in the foreign exchange market does not exist. We provide evidence against this view. The evidence comes from the introduction of trading in Tokyo over the lunch-hour. Lunch return variance doubles with the introduction of trading, which cannot be due to public information since the flow of public information did not change with the trading rules. Having eliminated public information as the cause, we exploit the volatility pattern over the whole day to discriminate between the two alternatives: private information and pricing errors. Three key results support the predictions of private-information models. First, the volatility U-shape flattens: greater revelation over lunch leaves a smaller share for the morning and afternoon. Second, the U-shape tilts upward, an implication of information whose private value is transitory. Finally, the morning exhibits a clear U-shape when Tokyo closes over lunch, and it disappears when trading is introduced.

Abstract:
It is a common view that private information in the foreign exchange market does not exist. We provide evidence against this view. The evidence comes from the introduction of trading in Tokyo over the lunch hour. Lunch return variance doubles with the introduction of trading, which cannot be due to public information since the flow of public information did not change with the trading rules. We then exploit recent results in microstructure to discriminate between the two alternatives: private information and pricing errors. Three key results support the predictions of private-information models. First, the volatility U-shape flattens: greater revelation over lunch leaves a smaller share for the morning and afternoon. Second, the U-shape tilts upward, an implication of information whose private value is transitory. Finally, the morning exhibits a clear U-shape when Tokyo closes over lunch, and it disappears when trading is introduced.

Abstract:
This paper develops a method for joint estimation of both the degree of internal returns to scale and the extent of external economies. We apply the method in estimating returns to scale indexes for U.S. manufacturing industries at the two-digit level. Overall, we find that only three of the twenty industry categories show any evidence of internal increasing returns: (1) Primary Metals, (2) Electrical Machinery, and (3) Paper Products. More striking, however, is the very strong evidence of the existence of external economies, where external is defined as external to a given two-digit industry and internal to the U.S.. According to our preferred estimates, if all manufacturing industries simultaneously raise their inputs by 10%, aggregate manufacturing production rises by 13%, of which about 5% is due to external economies. Thus, when an industry increases its inputs in isolation by 10%, its output rises by no more than 8%.

Abstract:
No abstract is available for this paper.

Abstract:
This paper shows there is a tradeoff between the speed of revelation and risk sharing in markets organized like spot foreign exchange. We show this by examining the following question: Would risk-averse dealers prefer ex-ante that order flow were observable? We answer this question with the solution to a mechanism design problem. The resulting incentive-efficient mechanism is one in which order flow is not generally observable. Rather, dealers prefer slower revelation because it permits additional risk-sharing. Specifically, additional trading opportunities in advance of revelation lowers the variance of unavoidable position disturbances, thereby reducing the marketmaking risk inherent in price discovery. We apply the framework to the spot foreign exchange market in order to understand better the current degree of transparency in that market.

Abstract:
No abstract is available for this paper.

Abstract:
No abstract is available for this paper.

Abstract:
No abstract is available for this paper.

Abstract:
This paper develops a two-period model of the spot foreign exchange market that emphasizes inter-dealer trading. At the outset, strategic risk-averse dealers each receive orders from non-dealer customers that are not generally observable. Then, dealers trade among themselves. Thus, each dealer intermediates his own customers' order-flow information. This information is subsequently revealed by the period-two price depending on (i) the signal value of inter-dealer trades, and (ii) the extent to which those trades are observable (transparent). As for the first of these two factors, the greater the risk aversion and market power of dealers the more garbled the signal in each trade. This garbling results in prices that are less revealing. The model also generates hot-potato trading--a term used in the literature to refer to the repeated passing of idiosyn- cratic inventory imbalances between dealers.

Abstract:
Intraday interest rates are zero. Consequently, a foreign exchange dealer can short a vulnerable currency in the morning, close this position in the afternoon, and never face an interest cost. This tactic might seem especially attractive in times of crisis, since it suggests an immunity to the central bank's interest rate defense. In equilibrium, however, buyers of the vulnerable currency must be compensated on average with an intraday capital gain as long as no devaluation occurs. That is, currencies under attack should typically appreciate intraday. Using data on intraday exchange rate changes within the European Monetary System, we find this prediction is borne out.

Abstract:
This paper addresses a fundamental tradeoff in the design of multiple-dealer markets. Namely, though greater transparency can accelerate revelation of information in price, it can also impede dealer risk management. If dealers could choose the transparency regime ex-ante, which regime would they choose? We show that dealers prefer incomplete transparency (meaning marketwide order-flow is observed with noise). Slower price adjustment provides time for non-dealers to trade, thereby sharing risk otherwise borne by dealers. At some point, however, further reduction in transparency impedes risk sharing: too noisy a public signal provides non-dealers too little information to induce them to trade.

Abstract:
This paper extends earlier work on FX microstructure by answering a number of key quantity-dependent questions. Earlier work was unable to address these questions because direct measures of quantity (order flow) were not available. For example, how profitable is dealing in FX? And how rapidly do FX dealers dispose of risky inventory compared to, say, NYSE equity specialists? Other questions are less straightforward, requiring some methodological progress. For example, what share of dealer profits come from speculation versus intermediation? To answer this question one needs a method for measuring dealer speculation over time. This paper introduces a method for doing this.Our answers to these questions are striking. First consider dealer profits: the dealer we track averages $100,000 profit per day (on volume of $1 billion per day). By comparison, equity dealers average about $10,000 profit per day (on volume of roughly $10 million per day). Further, we find that these profits derive primarily from intermediation rather than speculation. We also find intense inventory management: the half-life of non-zero positions is only 10 minutes. This is remarkably short relative to half-lives for equity specialists of one week. Inventory theory is clearly essential to understanding trading in this market. Though striking, these results also present a challenge: Why do equity and FX markets look so different in these dimensions?

Abstract:
The foreign exchange market is distinctive at the microstructural level. The three most striking features relative to other markets are: (1) trading volume is enormous, (2) the share of interdealer trading is very high, and (3) the transparency of order flow is very low. This paper introduces a model designed to capture these three features. The model includes multiple dealers who trade with customers and among themselves. In contrast to the sequential move framework of the canonical dealer trading game, here we introduce a simultaneous move trading game (with multiple periods). The model produces hot potato trading among dealers--a term that refers to repeated passing of inventory imbalances. This type of trading appears to account for much of the enormous volume in foreign exchange, and squares with the fact that the share of interdealer trading is very high. We show, however, that hot potato passing of inventories is not innocuous: because the passing of inventories dilutes the information content of order flow, this hampers information aggregation, making price less informative.