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

Abstract

Using incidences of negative bid-ask spreads as evidence of information events, I find the same population of dealers manages information risk differentially, depending on the probability of informed trading within foreign exchange markets. In markets with a positive probability of negative bid-ask spreads, dealers are willing to trade-off a longer duration to information revelation for higher bid-ask spreads and predictability in bid-ask spreads. In markets with a zero probability of negative bid-ask spreads, dealers arrive at information revelation faster but at the expense of relatively lower bid-ask spreads and significantly higher volatility in bid-ask spreads. These findings provide evidence that conditional on the information structure within foreign exchange markets, dealers can generate information either by attracting informed investors or discretionary liquidity traders into foreign exchange markets.