Bid, ask and transaction prices in a specialist market with heterogeneously informed traders

Glosten, Lawrence R.; Milgrom, Paul

doi:10.1016/0304-405x(85)90044-3

Cited by 5,068 publications

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“…We find that order size and currency spreads are negatively correlated and commercial customers are faced with higher spreads than financial customers. This contrasts with to standard adverse selection theory, which suggests that dealers increase spreads with a rising likelihood of private information indicated by customer type or order size (Glosten and Milgrom, 1985;Easley and O'Hara, 1987). Moreover, our dealer refrains from quote shading, i.e.…”

Section: End-user Order Flow and Exchange Rate Dynamics 1 1 Introductioncontrasting

confidence: 69%

“…The microstructure literature generally suggests that market making is performed under information asymmetry, implying that spreads should include an adverse-selection component that compensates dealers for losses to privately informed counterparties (Glosten and Milgrom, 1985;Kyle, 1985). Based on this literature, it is now commonly accepted that adverse selection costs are the primary channel through which asymmetric information affects spreads.…”

Section: Pricing Behavior Of An Fx Dealer In the Dollar-euro Marketmentioning

confidence: 99%

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End-User Order Flow and Exchange Rate Dynamics

2008

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Abstract:In this paper we provide evidence for Evans and Lyons' (2005b) model of an information aggregation process in FX markets using a German bank's end-user order flow from 2002 to 2003. Though customer order flow is unambiguously the vehicle incorporating non-public information into exchange rates over time, our empirical analysis does not support the widespread optimism in the market microstructure literature that customer order flow is the high-powered source of information easily exploitable for short-run speculation. Moreover, commercial customers' order flow produces negative coefficients in contemporaneous return regressions, stressing their role as liquidity providers. Keywords:Foreign exchange; market microstructure; end-user order flow JEL-Classification: F31 Non-technical summaryIn spite of many years of extensive research short-run exchange rate fluctuations still remain difficult to explain. The microstructure approach attempts to make progress in this respect by stressing the role of asymmetric information on foreign exchange markets.At the core of standard microstructure models a market maker is assumed to anonymously collect orders from informed and uninformed traders (Kyle, 1985). The market maker infers private information from informed traders by analyzing the incoming order flow and sets prices accordingly. As a result the microstructure approach suggests order flow as a major driving force of exchange rates dynamics. This paper empirically investigates FX dealer behavior in the Euro-US dollar market using the transaction data of a German bank in a one-year period from October 2002 to September 2003. In a first step, we estimate standard market microstructure models finding that order size and currency spreads are negatively correlated and commercial customers are faced with higher spreads than financial customers. This contrasts with standard adverse selection theory, which suggests that dealers increase spreads with a rising likelihood of private information indicated by customer type or order size (Glosten and Milgrom, 1985;Easley and O'Hara, 1987). Moreover, our dealer refrains from quote shading, i.e. he does not quote currency prices in order to manage inventory. Instead, undesired inventory is unloaded in the interdealer market.The empirical results in this section are in line with other studies such as and Osler et al. (2006), implying that the end-user order flow investigated here is similar to that of other dealing banks. This lends support to the view that the data set at hand is a representative fraction of market wide order flow. Thus, our second step is to use cointegration techniques to assess the information content of end-user order flow.In line with the price discovery process suggested by Evans and Lyons (2005b), we find that exchange rates are cointegrated with customer order flow. Within the cointegration relationship, exchange rates are positively related to financial customer orders and negatively related to commercial customer orders. In the short run, however, ne...

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Section: End-user Order Flow and Exchange Rate Dynamics 1 1 Introductioncontrasting

confidence: 69%

Section: Pricing Behavior Of An Fx Dealer In the Dollar-euro Marketmentioning

confidence: 99%

End-User Order Flow and Exchange Rate Dynamics

2008

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“…The assumption of risk neutrality implies that the market maker utility does not vary with inventory, which is in contrast to the empirical observation indicating that FX dealers manage inventory intensively. Moreover, the batch clearing of orders does not allow for bid-ask spreads as they arise naturally in sequential trade models (Glosten and Milgrom, 1985) or, more recently, in simultaneous-trade models like Lyons (1997). Since the focus of this paper is on investigating daily (or lower frequency) exchange rates before and after the introduction of a target zone, the simplifications made here seem to be reasonable.…”

Section: Market Maker's Pricing Behaviormentioning

confidence: 99%

Exchange Rate Dynamics in a Target Zone - A Heterogeneous Expectations Approach

Bauer

Reitz

2008

SSRN Journal

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The target zone model of Krugman (1991) has failed empirically. In this paper, we develop a model of the exchange rate with heterogeneous agents in a free floating and a target zone regime. We show that this simple model mimics the empirical puzzles of exchange rates: excessive volatility, fat tails, volatility clustering, and disconnection from the fundamentals. In addition, the target zone regime replicates a reduced nominal volatility for the same level of fundamental volatility as in the free floating regime and the distribution of the exchange rate within the band is hump-shaped.JEL Code: F31, F41.

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“…Transaction costs therefore represent a cash outflow that reduces future returns. Additionally, Glosten and Milgrom (1985) and Brennan and Subrahmanyam (1996) note that a primary cause of illiquidity in financial markets is the adverse selection, which arises from the presence of informed traders. If a marginal investor is uninformed, he may demand higher rates of return when the adverse selection problem is more severe.…”

Section: Introductionmentioning

confidence: 99%

Size, Value and Liquidity: Do They Really Matter on an Emerging Stock Market?

Lischewski

Voronkova

2010

SSRN Journal

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Die Dis cus si on Pape rs die nen einer mög lichst schnel len Ver brei tung von neue ren For schungs arbei ten des ZEW. Die Bei trä ge lie gen in allei ni ger Ver ant wor tung der Auto ren und stel len nicht not wen di ger wei se die Mei nung des ZEW dar.Dis cus si on Papers are inten ded to make results of ZEW research prompt ly avai la ble to other eco no mists in order to encou ra ge dis cus si on and sug gesti ons for revi si ons. The aut hors are sole ly respon si ble for the con tents which do not neces sa ri ly repre sent the opi ni on of the ZEW.Download this ZEW Discussion Paper from our ftp server:ftp://ftp.zew.de/pub/zew-docs/dp/dp10070.pdf Non-Technical SummaryThe paper provides new evidence on the factors that explain stock returns on the emerging markets. It focuses on the largest and most developed of the Central and Eastern European markets, the Polish stock market, which has been previously overlooked by the literature.In addition to the established factors, such as market, size and book-to-market value we investigate whether liquidity helps explaining Polish stock returns. The literature argues that liquidity should play a role on an emerging stock market where securities and investors are scarce and trading volumes are lower than on developed markets. The study is based on a hand-collected and carefully constructed dataset. In addition, our paper utilizes the largest array of liquidity measures considered in the literature to-date. In this way we ensure that our results are robust to multiple dimensions of liquidity. Our results support the hypothesis that the market, size, and book-to-market factors are important for explaining returns on the emerging Polish stock market. However, contrary to the expectations we do not find convincing evidence that liquidity is a priced factor. The results are robust across various liquidity measures and time periods. Das Wichtigste in Kürze AbstractThe paper extends the evidence on the factors relevant for pricing stocks in emerging markets. While previous literature focused on Latin American and Asian developing markets, Central and Eastern European markets remain under-researched. By focusing on the Polish stock market, we aim to fill in a gap in the asset pricing literature and draw attention to these previously overlooked markets. In addition to analyzing the importance of the most prominent risk-factors such as market, size and book-to-market value, we investigate whether liquidity plays a role in pricing Polish stocks. To test this conjecture we use the largest array of liquidity measures that has been used in the literature to date. We take advantage of a hand-collected dataset covering the longest period studied so far in case of the this market. Our results support existing evidence for developed markets with regard to the market, size, and book-to-market factor. However, in contrast to studies on other emerging markets, we do not find convincing evidence in favour of the liquidity risk premium on the Polish stock market. This result is robust acro...

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Bid, ask and transaction prices in a specialist market with heterogeneously informed traders

Cited by 5,068 publications

References 18 publications

End-User Order Flow and Exchange Rate Dynamics

End-User Order Flow and Exchange Rate Dynamics

Exchange Rate Dynamics in a Target Zone - A Heterogeneous Expectations Approach

Size, Value and Liquidity: Do They Really Matter on an Emerging Stock Market?

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