Abstract:

We analytically solve a Kyle model with an informed risk-averse speculator strategically trading in three connected asset markets satisfying a triangle relationship where a combination of two assets determines the value of the third (redundant) asset. Given private information on one asset, the speculator trades this asset directly in the corresponding market as well as indirectly via the triangle by simultaneously trading the other two assets. In equilibrium, the price informativeness is smaller, and the speculator trades more aggressively and earns higher profits in markets for assets that are more intensively used for indirect trading via the triangle. As an application to foreign exchange markets our model provides a market microstructure explanation based on asymmetric information for the high trading volume and low price impact for currency pairs that involve a vehicle currency (i.e., a trade via the triangle) such as the U.S. dollar.