Dealer Behavior and Trading Systems in Foreign Exchange Markets

Abstract

We study dealer behavior in the foreign exchange spot market using a detailed data set on the complete transactions of four dealers. There is strong support for an information effect in incoming trades. Although there is evidence that the information effect increases with trade size in direct bilateral trades, the direction of a trade seems to be more important. The large share of electronically brokered trades is probably responsible for this finding. In direct trades it is the initiating dealer that determines trade size, while in broker trades it is the dealer submitting the limit order that determines the maximum trade size. We also find strong evidence of inventory control for all the four dealers. Inventory control is not, however, manifested through a dealer's own prices as suggested in inventory models. This is different from the strong price effect from inventory control found in previous work by Lyons [J. Fin. Econ 39(1995) 321]. A possible explanation for this finding is that the introduction of electronic brokers allowed more trading options. Furthermore, we document differences in trading styles among the four dealers, especially how they actually control their inventories.

Exchange rates and order flow in the long run

“…7 Ibid. As mentioned above, this is the same measure of order flow used by Bjonnes and Rime (2005). 8 All figures and tables are in the paper's appendix.…”

“…The information associated with the order flow is of two types. 1 First, order flows are a signal of to the future expected value of the cash flows generated by the financial asset being exchanged. In the case of the foreign exchange market, these cash flows are associated with the interest rate differential between the two currencies involved.…”

“…Bjonnes and Rime (2005), Killeen et al (2006) and Rime (2001) note that this implies that the spot exchange rate should be cointegrated with the cumulated order flow. All three of these papers test for and present evidence of such cointegration.…”

Whose trades convey information? Evidence from a cross-section of traders

“…These characteristics are interpreted from the viewpoint of information processing, such that larger trade size or wider bid-ask spread convey information (Hasbrouck, 1991, Koski and Michaely, 2000, Hasbrouck and Seppi, 2001, Payne, 2003, Brandt and Kavajecz, 2004, Bjønnes and Rime, 2005.…”

An assessment of some open issues in the analysis of foreign exchange intervention

“…the imbalance between buyer-initiated and seller-initiated transactions, is an important determinant of exchange rate dynamics in the short and possibly even in the medium term. Indeed, empirical studies of the impact of order flow on exchange rates, notably Lyons (1995), Evans and Lyons (2002), Payne (2003) and Biønnes and Rime (2005), suggest that in FX markets order flow possesses an information content, as the impact of trade innovation on exchange rate is large, significant and persistent. There is also evidence, Evans and Lyons (2005), that order flow anticipates shifts in foreign exchange fundamentals.…”