Price Discovery within Foreign Exchange Markets and the Severity of Information Risk

Abstract

Juxtaposition of relative importance of risk aversion and information risk for maintenance of bid-ask spreads that always are positive reveal primacy of information risk over dealer risk aversion. While empirical results provide evidence for pricing of dealer risk aversion in context of a lower risk market, pricing of risk aversion cannot be dissociated from pricing of information risk. Within a higher risk market, shrinking of bid-ask spreads for inducement of information trades initially is accompanied by dealer risk neutrality, as opposed to risk aversion. Given bid-ask spreads move in step with information risk in context of the higher risk market, in presence of deviations from risk based pricing (risk neutrality), information risk continues to be priced. A formal theoretical model provides an arbitrage rationale for shrinkage of bid-ask spreads as appropriate response to either of arrival of informed traders, or inducement of informed traders into foreign exchange markets. The formal model, and empirical evidence confirm that some degree of currency information risk is necessary for well functioning of foreign exchange markets.

Keywords: Exchange Rates, Volatility, Inventory or Information Risk, Efficiency, Bid-Ask Spreads, Dealers, Risk Aversion, ARCH

JEL Classification: E44, E58