A simultaneous trade model of the foreign exchange hot potato

Abstract

This paper develops a simultaneous trade model of the spot foreign exchange market (cf., the sequential trade approach to dealing). The model produces hot-potato trading – a term that refers to the repeated passing of inventory imbalances between dealers. At the outset, risk-averse dealers receive customer orders that are not generally observable. Dealers then trade among themselves. Thus, each dealer intermediates both his customers' trades and any information contained therein. This information is subsequently revealed in price depending on the information in interdealer trades. We show that hot-potato trading reduces the information in interdealer trades, making price less informative.