An Empirical Study of Portfolio-Balance and Information Effects of Order Flow on Exchange Rates

1
An Empirical Study of Portfolio-Balance and
Information Effects of Order Flow on Exchange
Rates

• Group 6
• 8th Dec.2008

2
OUTLINE

• Abstract
• Data Analysis
• Model
• Intervention
• Conclusion
• Questions

3
Abstract

• Aims
• To disentangle the portfolio-balance and
  information effects of order flow on exchange
  rates, through a simple structural model of
  exchange rate determination
• Data
• Consists of inter-dealer trade in USD/EUR
  undertaken through the two major electronic limit
  order book trading systems employed in the spot
  FX market (EBS Reuters-D2, from 08/00 to 01/01)
• Results
• Strong contemporaneous correlation between
  order flow and exchange rate is largely due to
  portfolio-balance effects
• Keywords
• Order Flow, Foreign Exchange Microstructure,
  Exchange Rate Dynamics

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Data Analysis

?(it-it) ?(it-1-it-1) rt rt-1 Ot Ot-1
m?(it-it) 1.000000 0.306376 -0.260137 -0.048003 0.131069 0.072362
?(it-1-it-1) 1.000000 -0.091724 -0.251373 0.096816 0.117978
rt 1.000000 0.085646 -0.805875 -0.107502
rt-1 1.000000 -0.134207 -0.798079
ot 1.000000 0.220346
ot-1 1.000000
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Model

• We obtain the closed form solution for the
  exchange rate
• St?s,-1 St-1 ?f ft ?f,-1 f t-1 ?z zt ?z,-1
  zt-1 ?oot?o,-1ot-1?vvt
• where
• St Spot rate
• ft Fundamental variable
• Ot Order flow
• Vt Public signal
• ? Coefficiency
• z Supply

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• If we take differences, we obtain the following
  expression for the variation in the exchange rate
• St St-1?s,-1 (St-1-St-2)?f( ft - ft-1) ?f,-1
  (f t-1 ft-2)?zot ?z,-1 ot-1
• ?o (ot ot-1)?o,-1 (ot-1 ot-2)?v (ut -ut-1)
• Where
• St-1-St-2 The first lag of the spot rate
  variation
• ft - ft-1 The contemporaneous value
• f t-1 ft-2 The first lag of the variation in
  the fundamental value
• ot The contemporaneous value
• ot-1 The first lag of the order flow
• ot ot-1 The first lag of variation in the
  order flow
• ut -ut-1 The contemporaneous variation in
  the public signal

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GMM estimates of the model parameters, USD/EUR
market
All transactions EBS transactions D2 transactions
parameter value S.E (1) S.E (2) P-VAL value S.E (1) S.E (2) P-VAL value S.E (1) S.E (2) P-VAL
?b 0.127 0.083 0.092 0.240 0.070 0.082 0.0932 0.370 0.208 0.071 0.090 0.120
a 1.474 0.689 1.049 0.010 2.137 1.153 1.177 0.010 3.001 0.581 1.043 0.000
? 3.957   6.456 0.010 6.453   13.548 0.010 2.752   1.965 0.000
? 0.337 0.357 0.663 0.110 0.242 0.175 0.417 0.060 -0.054 0.112 0.192 0.440
?f 137.658       65.485     33.062      
?y 1.655       2.730     0.103      
?v 12.987       6.734     10.854      
?2 0.349       0.183   0.344      
R2 0.685     R2 0.379     R2 0.650    
P.O.R 0.636     P.O.R 0.863     P.O.R 0.288    
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Interventions

• Table 3 reports the estimated actual impact of
  intervention on the spot rate, order flow and the
  interest rate differential Evans, M.D., and R.K.
  Lyons, 2000, The Price Impact of Currency Trades
  Implications for Interventions, University of
  California at Berkeley mimeo.

22 Sep. 3 Nov. 6 Nov. 10 Nov. Average
Size of intervention 8.7bn 2.3bn 2.3bn 1.2bn 3.625bn
Actual Impact
On exchange rate -2.413 -0.653 0.834 0.568 -0.700
On order flow 800 289 141 227 364
On order flow() 2.3bn 0.835bn 0.407bn 0.656bn 1.05bn
On interest rates -0.1bp -0.7bp -4bp 2.2bp -0.7bp
Predicted Impact -1.685 -0.474 -0.188 -0.416 -0.691
Of order flow on exchange rate -0.003 -0.068 -0.155 0.100 -0.032
Of interest rates on exchange rate Total -1.688 -0.542 -0.343 -0.316 -0.722

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Conclusion

• Order flow moves exchange rates via the
  information channel
• Order flow affects currency values primarily via
  the portfolio-balance channel

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References

• Bacchetta, P., and E. van Wincoop, 2005, Can
  Information Heterogeneity Explain the Exchange
  Rate Determination Puzzle?, American Economic
  Review.
• Breedon, F., and Vitale P., 2005, An Empirical
  Study of Portfolio-Balance and Information
  Effects of Order Flow on Exchange Rates.
• Evans, M.D., and R.K. Lyons, 2000, The Price
  Impact of Currency Trades Implications for
  Interventions, University of California at
  Berkeley mimeo.
• Evans, M.D., and R.K. Lyons, 2005, Exchange Rate
  Fundamentals and Order Flow, University of
  California at Berkeley mimeo.

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ANY QUESTIONS ?
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THANK YOU FOR YOUR ATTENTION