RDP 8707: Asymmetric Information and Bid-Ask Spreads in the Eurocurrency Markets 6. Conclusions

Our analysis has suggested a simple and intuitively plausible relationship between the information structure of a market, and the bid-ask spread of a competitive security dealer. This relationship can be summarised as follows: the size of the spread is positively related to the degree of asymmetry in the information structure, and is inversely related to the degree of pure uncertainty. In Section 5 it was argued that this result can be used as a basis for testing for the presence of asymmetric information effects in the foreign exchange market. The method was to test the significance of variables measuring bid-ask spreads as predictors of the mean and variance of future exchange rates. These data have not previously been used in empirical studies of exchange rate movements.

The results were in broad agreement with the qualitative predictions of the model. Informational effects captured by the spreads were significant in almost all the exchange rate equations, and were consistent in sign with the interpretation that asymmetric information effects make a relatively large contribution to total uncertainty. These effects were not however large enough to explain the failure of the uncovered interest parity condition, which remains a puzzle in empirical finance. The results obtained in this study deserve to be emphasised because they represent the first attempt to find direct evidence concerning asymmetric information effects in the foreign exchange market. This is in contrast to standard studies of informational efficiency which are of a joint nature and therefore offer no obvious interpretation as to the reason for any failure of the joint hypothesis.