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Optimal Transparency in a Dealership Market with an Application to Foreign Exchange

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  • Richard K. Lyons.

Abstract

This paper addresses the issue of optimal transparency in a multiple-dealer market. In particular, we examine the question: Would risk-averse dealers prefer ex-ante that signed 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 signed order flow is not observable. Rather, dealers prefer a slower pace of price discovery because it induces additional risk-sharing. Specifically, slower price discovery permits additional trading with customers prior to revelation; this reduces the variance of unavoidable position disturbances, thereby reducing the marketmaking risk inherent in price discovery. We then apply the framework to the spot foreign exchange market in order to understand better the current degree of transparency in that market.

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Bibliographic Info

Paper provided by University of California at Berkeley in its series Research Program in Finance Working Papers with number RPF-231.

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Date of creation: 01 Sep 1993
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Handle: RePEc:ucb:calbrf:rpf-231

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Postal: University of California at Berkeley, Berkeley, CA USA
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Postal: IBER, F502 Haas Building, University of California at Berkeley, Berkeley CA 94720-1922
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References

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  1. Leach, J Chris & Madhavan, Ananth N, 1993. "Price Experimentation and Security Market Structure," Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 375-404.
  2. Lyons, Richard K., 1990. "Whence exchange rate overshooting: Money stock or flow?," Journal of International Economics, Elsevier, vol. 29(3-4), pages 369-384, November.
  3. Bray, Margaret M, 1981. "Futures Trading, Rational Expectations, and the Efficient Markets Hypothesis," Econometrica, Econometric Society, vol. 49(3), pages 575-96, May.
  4. Wolinsky, Asher, 1987. "Information Revelation in a Market with Pairwise Meetings," The Warwick Economics Research Paper Series (TWERPS) 284, University of Warwick, Department of Economics.
  5. Myerson, Roger B, 1986. "Multistage Games with Communication," Econometrica, Econometric Society, vol. 54(2), pages 323-58, March.
  6. Myerson, Roger B. & Satterthwaite, Mark A., 1983. "Efficient mechanisms for bilateral trading," Journal of Economic Theory, Elsevier, vol. 29(2), pages 265-281, April.
  7. Biais, Bruno, 1993. " Price Information and Equilibrium Liquidity in Fragmented and Centralized Markets," Journal of Finance, American Finance Association, vol. 48(1), pages 157-85, March.
  8. Lyons, Richard K., 1995. "Tests of microstructural hypotheses in the foreign exchange market," Journal of Financial Economics, Elsevier, vol. 39(2-3), pages 321-351.
  9. Laffont, Jean-Jacques & Maskin, Eric S, 1990. "The Efficient Market Hypothesis and Insider Trading on the Stock Market," Journal of Political Economy, University of Chicago Press, vol. 98(1), pages 70-93, February.
  10. Ho, Thomas S Y & Stoll, Hans R, 1983. " The Dynamics of Dealer Markets under Competition," Journal of Finance, American Finance Association, vol. 38(4), pages 1053-74, September.
  11. Diamond, Douglas W. & Verrecchia, Robert E., 1981. "Information aggregation in a noisy rational expectations economy," Journal of Financial Economics, Elsevier, vol. 9(3), pages 221-235, September.
  12. Goodhart, Charles, 1988. "The Foreign Exchange Market: A Random Walk with a Dragging Anchor," Economica, London School of Economics and Political Science, vol. 55(220), pages 437-60, November.
  13. Mark D. Flood, 1991. "Microstructure theory and the foreign exchange market," Review, Federal Reserve Bank of St. Louis, issue Nov, pages 52-70.
  14. Kyle, Albert S, 1989. "Informed Speculation with Imperfect Competition," Review of Economic Studies, Wiley Blackwell, vol. 56(3), pages 317-55, July.
  15. Garman, Mark B., 1976. "Market microstructure," Journal of Financial Economics, Elsevier, vol. 3(3), pages 257-275, June.
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Cited by:
  1. Richard K. Lyons., 1993. "Tests of Microstructural Hypotheses in the Foreign Exchange Market," Research Program in Finance Working Papers RPF-230, University of California at Berkeley.
  2. Nicolas Audet & Toni Gravelle & Jing Yang, 2002. "Alternative Trading Systems: Does One Shoe Fit All?," Working Papers 02-33, Bank of Canada.
  3. Richard K. Lyons, 1995. "Foreign Exchange Volume: Sound and Fury Signifying Nothing?," NBER Working Papers 4984, National Bureau of Economic Research, Inc.
  4. Vogler, Karl-Hubert, 1997. "Risk allocation and inter-dealer trading," European Economic Review, Elsevier, vol. 41(8), pages 1615-1634, August.
  5. Victoria Saporta, 1997. "Which Inter-dealer Market Prevails? An analysis of inter-dealer trading in opaque markets," Bank of England working papers 59, Bank of England.

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