Profitability in an Electronic Foreign Exchange Market: Informed Trading or Differences in Valuation?

Fundamental spot exchange rate models preclude the existence of asymmetric information in foreign exchange markets. This article critically investigates the possibility that private information arises in the spot foreign exchange market. Using a rich dataset, we first empirically detect transaction behavior consistent with the informed trading hypothesis. We then work within the theoretical framework of a high-frequency version of a structural microstructure trade model, which directly measures the market maker’s beliefs. We find that the time-varying pattern of the probability of informed trading is rooted in the strategic arrival of informed traders on a particular hour-of-day, day-of-week, or geographic location (market)