EXCHANGE RATE ECONOMICS LECTURE 3 ASYMMETRIC INFORMATION AND EXCHANGE RATES. A. Portfolio Shifts Model and the Role of Order Flow

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1 EXCHANGE RATE ECONOMICS LECTURE 3 ASYMMETRIC INFORMATION AND EXCHANGE RATES A. Porfolio Shifs Model and he Role of Order Flow Porfolio shifs by public cause exchange rae change no common knowledge when hey occur large enough ha marke clearing requires exchange rae o change There are T periods & asses: riskless & fx wih sochasic payoff F F where innovaions are iid ~ N( 0, Σ ) = T r = 1 r observed before rading each period (public info.) Decenralized marke wih N dealers i and coninuum of non-dealer cusomers all have idenical neg. exponenial uil. defined over wealh a T 3 rading rounds each day r M. Melvin,

2 TRADING ROUND 1 a) observe r a beginning of period b) all dealers simulaneously & independenly quoe a scalar price Pi1 a which any amoun may be bough or sold c) cusomer orders ci1 a Pi1 ci1 < 0 is cusomer sale (dealer buy) ci1 ~ N( 0, Σ c1 ) for each of N orders orders are indep. across dealers orders are disribued indep. of public info. r hese are he porfolio shifs ha are no publicly observable M. Melvin, 004.

3 TRADING ROUND a) each dealer simulaneously & indep. quoes a scalar price o oher dealers Pi a which any amoun may be bough & sold inerdealer quoes observable & available o all dealers b) dealers rade on oher's quoes a any given P, orders evenly spli across any dealers quoing ha P x = N T i i = 1 is ne inerdealer order flow inerdealer rade ransparen o all dealers (no noise) M. Melvin,

4 TRADING ROUND 3 a) dealers quoe scalar price Pi3 Pi3 condiioned on inerdealer order flow (dealers know amoun public mus absorb) any amoun may be raded observable & available o public a large public absorbs dealer unwaned invenory each dealer ends day wih 0 ne posiion b) public rades a Pi3 c3 = γ ( E [ P3, + 1 Ω 3 ] P3, ) so public's oal demand is funcion of expeced reurn γ capures agg. risk-bearing capaciy of public M. Melvin,

5 EQUILIBRIUM Dealer's problem is: max E [ exp( θw i3 s.. Ω i )] wi3 = wi0 + ci1( Pi1 ' Pi ) + ( Di + ' E [Ti Ω i ])( Pi3 ' Pi ) ' ( Ti Pi3 Pi ' denoes inerdealer quoe or rade yields price equaion: P = r + λ x for r use (i-i*) esimae: P = β1 ( i i * ) + β x + η M. Melvin,

6 ESTIMATION Daa: Reuers Dealing *ime, price, and signed rade (+ buy, - sell) *no quaniy, no quoes *ake price from 4pm o 4pm GMT *(i-i*) overnigh raes from Daasream (4pm GMT) Sig. & pos. order flow effec *high R *esimaes indicae ha day wih 1000 more purchases han sales DM/$ by.1% If order flow drives prices, wha drives order flow? References Evans & Lyons, "Order Flow and Exchange Rae Dynamics," JPE, 000 (hp:// M. Melvin,

7 ASYMMETRIC INFORMATION AND PRICE DISCOVERY IN THE FX MARKET: Does Tokyo Know More Abou he Yen? Viceniu Covrig and Michael Melvin M. Melvin,

8 I. INTRODUCTION Microsrucure heory informed rader presence affecs marke dynamics Empirical problem: idenifying informed Suggesed experimen: Tokyo pre- and pos-dec., 1994 Io, Lyons, and Melvin, Journal of Finance, *Informed rader concenraion in pre-lunch BEFORE period M. Melvin,

9 Some iniial sylized facs: U-shaped volailiy for Japan BEFORE no U-shape for non-japan BEFORE no U-shape for eiher AFTER Wha kind of privae informaion? cusomer order flow early knowledge of governmen acion invenory posiions GOAL: Tes implicaions of microsrucure heories regarding marke dynamics wih many informed raders presen M. Melvin,

10 II. IMPLICATIONS OF INFORMED TRADER CONCENTRATION A. A Represenaive Theory ( 1) F = F + δ. ( ) P = F + λω, Informed rader demand: β ( δ + u) ( 3) β = 1/{(1+ φ) λ( + 1) + A[ φ + λ σ z (1+ φ)]} 4) λ[ k (1 + φ) + σ Z α ] = kα (, k, α = β 1 = [ φ + λ (1 + φ) σ ] + ( k + 1) λ(1+ φ ) z A. informaional efficiency, ( 5) Q 1+ {1/[ φ + ( σ / k β z ]} =, Q = [var( δ ω)] 1 IMPLICATION: Prices are more informaive and converge more quickly o full informaion levels when here are many informed raders in he marke M. Melvin,

11 B. Esimaing Speed of Adjusmen Sample *10:30-1noon Tokyo *0 days BEFORE and AFTER *Reuers quoes on yen/dollar *1-minue reurns MA(1)-GARCH(1,1) () 6 r = α + ε 0 + α ε 1 1 () 7 h * * = γ + γ h dum h dum γ ε 1 + γ γ ε 4 1 Esimaed half-life of shock o volailiy: ½ minues BEFORE 14 minues AFTER M. Melvin,

12 III. JAPANESE AND NON-JAPANESE BANK DYNAMICS If Tokyo knows more, hen Japanese quoes should lead non-japanese? Causaliy ess: ( 9) r d a br i cr d = e Sample: *0 days BEFORE and AFTER *early-morning, lae-morning, and afernoon *filer ick-by-ick r i reurns.5 basis poins *consruc r d reurns around r i FINDINGS: *-way causaliy in all periods bu one *Japan causes non-japan in lae-morning BEFORE M. Melvin,

13 Nonsynchronous Quoing and Cross Correlaions Difference beween observed quoes equals sums of reurns of underlying unobserved quoe process (i) i + 1 q q = q i + 1 [ ] J J N N (ii) E( y ) = E ( q q )( q q ) ij = E i + 1 q = i + 1 i J i + 1 k j + 1 i q J = i + 1 k = k j + 1 N s j + 1 = i + 1 j j + 1 γ k = i + 1k = j + 1 (ii) γ k = Cov( r, r k ), r q q 1 N (iii) χ k) max[ 0,min(, + k) max(, )] ij ( = i + 1 j + 1 i j + k (iv) (v) E( y ij χ ) = χ ( l ) γ ij ij ij y = χ γ + e k k = k ij ij c k for k = 5, Wald es for lead/lag: q J lead q N BEFORE 16. AFTER 1.6 q N lead q J M. Melvin,

14 IV. PRICE DISCOVERY IN JAPAN AND ELSEWHERE Follow Hasbrouck (1995) o esimae conribuion of Japanese and non-japanese quoes o price discovery ( 10) r = Ψ( L) e ( 11) r = α( β' q 1 Eβ ' q + Γ k 1 r k+ 1 + e ) + Γ 1 r 1 + Γ r +... e = Fz, Ez = 0, Var(z ) = I ( 1) S ([ ] ) j = ψf j /( ψωψ ' ) M. Melvin,

15 Japanese/non-Japanese info. share: BEFORE 96% AFTER 89% Japanese/Hong Kong info. share: BEFORE 18% AFTER 111% Japanese conribuion o price discovery higher BEFORE han AFTER M. Melvin,

16 V. CONCLUSIONS Marke dynamics differ depending upon he presence of informed raders *greaer he number of informed raders he faser price adjuss o full-informaion value *informed-rader quoes lead he res of he marke when high concenraion of informed raders *informed raders conribuion o price discovery peaks when informed cluser Does Tokyo Know More Abou he Yen? *qualified yes... Reference: hp:// M. Melvin,

17 Figure 1: Variance of Yen/Dollar Quoes in Asian Morning -- BEFORE Variance am am 11-1 am Japan Non-Japan Variance Figure : Variance of Yen/Dollar Quoes in Asian Morning -- AFTER 9-10am am 11-1 am Japan Non-Japan M. Melvin,