Private information and its origins in an electronic foreign exchange market

In most cases authors are permitted to post their version of the article (e.g. in Word or Tex form) to their personal website or institutional repository. Authors requiring further information regarding Elsevier's archiving and manuscript policies are encouraged to visit: a b s t r a c t a r t i c l e i n f o Available online xxxx JEL classification: G0 G1 F3 Keywords: Foreign exchange markets Private information Informed trading Noise trading We study the risk of informed trading in an electronic foreign exchange market and test whether informed trading is driven by marketwide private information. Our framework is based on a structural microstructure trade model that measures the market makers' beliefs directly. Evidence of high concentration of informed trades is found to be inversely related to the overall 24-hour trading activity, i.e., early morning and late afternoon GMT rounds of trading involve the highest risk of informed trading. We structurally identify that the trades due to region-specific private information are dominant and explain between 5 and 25% of the variation in currency returns. In contrast, marketwide private information explains only about 1–5% of the variation in returns. Structural macroeconomic spot exchange rate models ignore the role of asymmetric information in exchange rate determination. These models assume that markets are efficient in the sense that information is widely available to all market participants and that all relevant and ascertainable information is already reflected in exchange rates. In other words, from this point of view, exchange rates are not informed by microstructure variables. Even if price effects from currency order flows arise, they are quickly incorporated through the error term of an exchange rate equation. Furthermore, as currency valuation depends primarily on macroeconomic information, the absence of firm-specific information implies a reduced potential for market maker losses to better informed traders (Bessembinder, 1994). In this context, the existence of private information in the foreign exchange (FX) market implies traders privately informed about macroeconomic fundamentals. 3 However, the large volatility of currency returns can not be understood by the slow-moving macroeconomic variables. In an alternative view, private information in the FX market can originate from proprietary trading models and non-common knowledge private news sources such as direct interdealer transactions and customer orders (Evans, 2002). For example, Lyons (2001) notes that currency orders from firms engaged in international trade convey private signals about the shift in demand for …