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Outline: 1. Description of Foreign Exchange Trading
Outline: 1. Description of Foreign Exchange Trading
Literature:
Madhavan, A., and S. Smidt. 1991. A Bayesian model of intraday
specialist pricing. Journal of Financial Economics 30: 99134.
Reitz, S., Schmidt, M., and M.P. Taylor, 2011, End-User Order Flow
and Exchange Rate Dynamics, European Journal of Finance Vol. 17, 153 -168
Transaction costs
We assume a fixed transaction cost
component per trade
Denote Dt as a trade direction indicator such
that
Dt = 1, if a customer buys foreign currency
Dt = -1, if a customer sells foreign currency.
Inventory effects
We assume the market maker dislikes
deviations of current inventory It from a desired
inventory level Id.
In case of excess inventory, she lowers prices
at a rate of (I t I d )
The coefficient measures the speed of
adjustment (urgency of adjustment).
Of course, may vary over a trading day.
(Why?)
Asymmetric information
Suppose the market maker is asked for quotes
by an international hedge fund
good for USD 100 mill.
What is the market makers problem?
The possibility of an important piece of
information in the hand of the customer should
be considered in the pricing schedule
The market maker tries to hedge the risk of
information disadvantage.
pt = t (I t I d ) + Dt (1)
Information processing
Just before time t all agents observe a noisy
public information signal
yt = t + t where t ~ iid . N ( 0, 2
)
Information processing
Bayesian learning leads to the customers
posterior expectation of the true value
2
mt = wt + (1 ) y t , where = 2 (2)
+ 2
qt = (mt pt ) xt (3)
Information processing
Liquidity shock xt is private information, but
across all customers it is assumed that
xt ~ iid . N (0, ) 2
x
Information processing
From (2) and (3) the market maker knows
qt = (wt + (1 ) y t pt ) xt
pt + qt (1 ) yt + xt
wt =
Remember that xt is zero across all customers
pt + qt (1 ) yt
E [wt qt ] = (4)
Information processing
Combining this info with the public prior gives
s2
t = yt + (1 )E [wt qt ] where = 2 or
s + 2
qt
t = y t + (1 ) pt + , where = ( + 1) / (5)
pt = y t + Dt
Conclusions 1
Asymmetric information forces the market
maker to increase exchange rates when
customers buy foreign exchange and vice
versa.
By charging customers in the described
fashion the market maker is compensated for
her information disadvantage.
Asymmetric information opens the door for
order flow as an important driver of exchange
rates
Prof. Reitz FX Markets - Theory and Empirics 16
2. The Dealers Perspective___________________________________________________________
Conclusions 2
There is no Walrasian auctioneer clearing the
market. Since the market makers always
agrees to trade she accumulates positions of
foreign currency Inventory considerations
In contrast to Rational Expectations models
orders precede prices changes!
Conclusions 3
A net market surplus of foreign currency
imposes a pressure on exchange rates via the
inventory component. Depending on market
clearing may take some time!
Transaction costs and asymmetric information
costs give rise to so-called bid/ask spreads.
Empirical Evidence
Eq. (6) cannot be estimated because the
market makers prior yt is unobservable.
The MS(1991) solution to the problem is to add
yt to either side of lagged (1) to get
y t + pt 1 = t 1 (I t 1 I d ) + Dt 1 + y t
y t = pt 1 + (I t 1 I d ) Dt 1 + y t t 1 (7)
Empirical Evidence
(7) in (6):
Pt = + qt I t + I t 1 + Dt Dt 1 + t (8)
Data set
Tick-by-tick data from a German bank
Data from Oct. 1st, 2002 to Sept. 30th, 2003
(254 trading days, 11,830 transactions)
Trade records contain
currency pair
date and time of trade
trade direction
deal size and transaction price
counterparty type and trade initiator
Source: Reitz et al. (2010)
Data set
Table 1
Trading activity of a small German bank
254 trading days between October 1st , 2002 and September 30th, 2003
Financial Commercial Internal Interbank All Transactions
Customers Customers Customers
Incoming transactions 189 5,229 639 5,773 11,830
Deal Size Qit 0.34 (0.13)** Large 0.06 (0.08) Commercial 0.94 (0.17)***
Small 20.2 (2.10)*** Financial 0.09 (0.09)
Internal 0.29 (0.14)**
Inventory It 0.01 (0.07) Large 0.03 (0.07) Commercial 0.04 (0.07)
Small 0.03 (0.07) Financial 0.04 (0.07)
Internal 0.03 (0.09)
Lagged Inventory 0.001 (0.07) Large 0.04 (0.07) Commercial 0.03 (0.07)
It-1 Small 0.02 (0.07) Financial 0.05 (0.07)
Internal 0.16 (0.12)
Direction Dt 6.48 (0.20)*** Large 2.13 (0.21)*** Commercial 9.47 (0.19)***
Small 11.5 (0.26)*** Financial 2.04 (0.21)***
Internal 14.8 (1.08)***
Lagged Direction 5.82 (0.18)*** Large 1.17 (0.15)*** Commercial 9.84 (0.20)***
Dt-1 Small 10.3 (0.26)*** Financial 0.94 (0.15)***
Internal 14.3 (1.50)***
R2 0.23 0.33 0.34
Deal Size Qit 0.34 (0.13)** Large 0.06 (0.08) Commercial 0.94 (0.17)***
Small 20.2 (2.10)*** Financial 0.09 (0.09)
Internal 0.29 (0.14)**
Inventory It 0.01 (0.07) Large 0.03 (0.07) Commercial 0.04 (0.07)
Small 0.03 (0.07) Financial 0.04 (0.07)
Internal 0.03 (0.09)
Lagged Inventory 0.001 (0.07) Large 0.04 (0.07) Commercial 0.03 (0.07)
It-1 Small 0.02 (0.07) Financial 0.05 (0.07)
Internal 0.16 (0.12)
Direction Dt 6.48 (0.20)*** Large 2.13 (0.21)*** Commercial 9.47 (0.19)***
Small 11.5 (0.26)*** Financial 2.04 (0.21)***
Internal 14.8 (1.08)***
Lagged Direction 5.82 (0.18)*** Large 1.17 (0.15)*** Commercial 9.84 (0.20)***
Dt-1 Small 10.3 (0.26)*** Financial 0.94 (0.15)***
Internal 14.3 (1.50)***
R2 0.23 0.33 0.34
Deal Size Qit 0.34 (0.13)** Large 0.06 (0.08) Commercial 0.94 (0.17)***
Small 20.2 (2.10)*** Financial 0.09 (0.09)
Internal 0.29 (0.14)**
Inventory It 0.01 (0.07) Large 0.03 (0.07) Commercial 0.04 (0.07)
Small 0.03 (0.07) Financial 0.04 (0.07)
Internal 0.03 (0.09)
Lagged Inventory 0.001 (0.07) Large 0.04 (0.07) Commercial 0.03 (0.07)
It-1 Small 0.02 (0.07) Financial 0.05 (0.07)
Internal 0.16 (0.12)
Direction Dt 6.48 (0.20)*** Large 2.13 (0.21)*** Commercial 9.47 (0.19)***
Small 11.5 (0.26)*** Financial 2.04 (0.21)***
Internal 14.8 (1.08)***
Lagged Direction 5.82 (0.18)*** Large 1.17 (0.15)*** Commercial 9.84 (0.20)***
Dt-1 Small 10.3 (0.26)*** Financial 0.94 (0.15)***
Internal 14.3 (1.50)***
R2 0.23 0.33 0.34
No price shading
Dealers tend to control inventory using
interdealer markets
Half spreads quite large for small
trades/commercial customers
Weight put on order flow information is
11% on average
54% for financial customers
Stat. insignificant for comm. and internal
customers
Prof. Reitz FX Markets - Theory and Empirics 26
Empirical Evidence
Bayesian Learning
Bayesian Learning
1. How is information contained in the order flow
revealed? An example!
Clients buy
1.2
Clients sell
Pt = 1
Clients buy
0.8
Clients sell
Bayesian Learning
1. Probabilities!
Clients buy
0.7
1.2
0.5 0.3 Clients sell
Pt = 1
0.5 0.4 Clients buy
0.8
0.6
Clients sell
Bayesian Learning
1. Probabilities!
Clients buy
P(bup)
1.2
P(up) P(sup) Clients sell
Pt = 1
P(do) Clients buy
P(bdo)
0.8
P(sdo)
Clients sell
Bayesian Learning
1. What is the probability that the true value has
gone up given that we observe clients buying?
2. Similarly
Bayesian Learning
1. From the numerical example, we have
Bayesian Learning
Given his prior (public) information