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Asymmetric Price Impacts of Order Flow on Exchange Rate Dynamics

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  • Viet Hoang Nguyen

    ()
    (Melbourne Institute of Applied Economic and Social Research, The University of Melbourne)

  • Yongcheol Shin

    (Leeds University Business School, The University of Leeds)

Abstract

We generalize the portfolio shifts model advanced by Evans and Lyons (2002a; b), and develop the dynamic asymmetric portfolio shifts (DAPS) model by explicitly allowing for possible market under- and overreactions and for asymmetric pricing impacts of order flows. Using the Reuters D2000-1 daily trading data for eight currency markets over a four-month period from 1 May to 31 August 1996, we find strong evidence of a nonlinear cointegrating relationship between exchange rates and (cumulative) order flows: The price impact of negative order flows (selling pressure) is overwhelmingly stronger than that of the positive ones (buying pressure). Through the dynamic multiplier analysis, we find two typical patterns of the price discovery process. The markets following overreactions tend to display a delayed overshooting and a volatile but faster adjustment towards equilibrium whereas the markets following underreactions are generally characterized by a gradual but persistent adjustment. In our model, these heterogeneous adjustment patterns reflect different liquidity provisions associated with different market conditions following under- and overreactions. In addition, the larger is the mispricing, the faster is the overall adjustment speed, a finding consistent with Abreu and Brunnermeier (2002) and Cai et al. (2011). We also find that underreactions are followed mostly by positive feedback trading while overreactions are characterized by delayed overshooting in the short run but corrected by negative feedback trading at longer horizons, the finding is consistent with Barberis et al. (1998) who show that positive short-run autocorrelations (momentum) signal underreaction while negative long-run autocorrelations (reversal) signal overreaction.

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Bibliographic Info

Paper provided by Melbourne Institute of Applied Economic and Social Research, The University of Melbourne in its series Melbourne Institute Working Paper Series with number wp2011n14.

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Length: 40 pages
Date of creation: Jun 2011
Date of revision:
Handle: RePEc:iae:iaewps:wp2011n14

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Related research

Keywords: Exchange rate; order flow; under- and overreaction; asymmetric pricing impacts; asymmetric cointegrating relationship and dynamic multipliers;

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References

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  1. Martin Evans, 2000. "FX trading and Exchange Rate Dynamics," Working Papers gueconwpa~00-00-04, Georgetown University, Department of Economics.
  2. De Long, J Bradford, et al, 1990. " Positive Feedback Investment Strategies and Destabilizing Rational Speculation," Journal of Finance, American Finance Association, vol. 45(2), pages 379-95, June.
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  4. Anderson, Torben G. & Bollerslev, Tim & Diebold, Francis X. & Vega, Clara, 2002. "Micro Effects of Macro Announcements: Real-Time Price Discovery in Foreign Exchange," Working Papers 02-1, University of Pennsylvania, Wharton School, Weiss Center.
  5. M. Martin Boyer & Simon van Norden, 2006. "Exchange Rates and Order Flow in the Long Run," CIRANO Working Papers 2006s-07, CIRANO.
  6. Martin Evans and Richard K. Lyons, 2002. "Informational Integration and FX Trading," Working Papers gueconwpa~02-02-11, Georgetown University, Department of Economics.
  7. Evans, Martin D. D. & Lyons, Richard K., 2002. "Time-varying liquidity in foreign exchange," Journal of Monetary Economics, Elsevier, vol. 49(5), pages 1025-1051, July.
  8. Benjamin Cohen & Hyun Song Shin, 2002. "Positive feedback trading under stress: evidence from the US Treasury securities market," BIS Papers chapters, in: Bank for International Settlements (ed.), Market functioning and central bank policy, volume 12, pages 148-180 Bank for International Settlements.
  9. Martin D. D. Evans & Richard K. Lyons, 2005. "Understanding Order Flow," NBER Working Papers 11748, National Bureau of Economic Research, Inc.
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  13. Martin D.D. Evans & Richard K. Lyons, 1999. "Order Flow and Exchange Rate Dynamics," NBER Working Papers 7317, National Bureau of Economic Research, Inc.
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  22. Andrew B. Abel, 1998. "Risk Premia and Term Premia in General Equilibrium," NBER Working Papers 6683, National Bureau of Economic Research, Inc.
  23. Martin D.D. Evans & Richard K. Lyons, 2005. "Do Currency Markets Absorb News Quickly?," NBER Working Papers 11041, National Bureau of Economic Research, Inc.
  24. Evans, Martin D.D. & Lyons, Richard K., 2008. "How is macro news transmitted to exchange rates?," Journal of Financial Economics, Elsevier, vol. 88(1), pages 26-50, April.
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Cited by:
  1. Lovcha, Yuliya & Perez-Laborda, Alejandro, 2013. "Is exchange rate – Customer order flow relationship linear? Evidence from the Hungarian FX market," Journal of International Money and Finance, Elsevier, vol. 35(C), pages 20-35.
  2. Verheyen, Florian, 2013. "Exchange rate nonlinearities in EMU exports to the US," Economic Modelling, Elsevier, vol. 32(C), pages 66-76.

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