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Private Beliefs and Information Externalities in the Foreign Exchange Market

  • Richard K. Lyons

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.

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File URL: http://www.nber.org/papers/w3889.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3889.

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Date of creation: Oct 1991
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Publication status: published as Journal of International Economics, new title," A Simultaneous Trade Model of the Foreign Exchange Hot Potato", February 1997vol. 36.
Handle: RePEc:nbr:nberwo:3889
Note: ITI IFM
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  1. Hal R. Varian, 1986. "Differences of opinion in financial markets," Proceedings, Federal Reserve Bank of St. Louis, pages 3-40.
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  4. Hirshleifer, Jack, 1971. "The Private and Social Value of Information and the Reward to Inventive Activity," American Economic Review, American Economic Association, vol. 61(4), pages 561-74, September.
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  7. Hellwig, Martin F., 1980. "On the aggregation of information in competitive markets," Journal of Economic Theory, Elsevier, vol. 22(3), pages 477-498, June.
  8. Stein, Jeremy C, 1987. "Informational Externalities and Welfare-Reducing Speculation," Journal of Political Economy, University of Chicago Press, vol. 95(6), pages 1123-45, December.
  9. Rubinstein, Mark, 1975. "Securities Market Efficiency in an Arrow-Debreu Economy," American Economic Review, American Economic Association, vol. 65(5), pages 812-24, December.
  10. Jeffrey Frankel and Kenneth Froot., 1991. "Exchange Rate Forecasting Techniques, Survey Data, and Implications for the Foreign Exchange Market," Economics Working Papers 91-158, University of California at Berkeley.
  11. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, vol. 14(1), pages 71-100, March.
  12. Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society, vol. 50(5), pages 1163-81, September.
  13. 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.
  14. 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.
  15. Jaffe, Jeffrey F & Winkler, Robert L, 1976. "Optimal Speculation against an Efficient Market," Journal of Finance, American Finance Association, vol. 31(1), pages 49-61, March.
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