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A Microstructure Model for Spillover Effects in Price Discovery: A Study for the European Bond Market

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  • Perlin, Marcelo
  • Dufour, Alfonso
  • Brooks, Chris

Abstract

This paper is set to investigate the existence of spillover effects for the trading process of correlated financial instruments. While the main literature in price impact models has focused mainly on multivariate processes for a unique asset, we argue that transitory spillover effects in such class of models should exist as a simple biproduct of explicit relationships among prices of different (but correlated) financial instruments. Firstly we assess the theoretical implications of a transitory spillover effect in an extended microstructure model and then we investigate our different hypothesis in the European bond market with a formal econometric model. The results showed that the estimated parameters of the econometric models do conform to what we expect in the theoretical derivations, where the trades of one instrument would be correlated to the trades in others. But, even though the results are positive, they could also be explained by traders splitting orders across different instruments or joint periods of intensive trading. Further analysis also showed that the trading intensity in other instruments does affect the trading process of the particular bonds. We found that a buy (sell) order is less likely to be followed by a buy (sell) order if the market is trading intensively. We explain such effect as an inventory problem, where volatility of prices forces market makers to improve trades in the opposite direction from the current order flow. The main conclusion of this study is that we find inconclusive results towards the particular microstructure model set in the theoretical part of the paper, but positive results for a general spillover effect in the trading process of European fixed income instruments.

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File URL: http://mpra.ub.uni-muenchen.de/23380/
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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 23380.

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Date of creation: Jun 2010
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Handle: RePEc:pra:mprapa:23380

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Keywords: market microstructure; spillover effect; commonalities; liquidity; price impact of a trade.;

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  1. Dufour, Alfonso & Engle, Robert F, 1999. "Time and the Price Impact of a Trade," University of California at San Diego, Economics Working Paper Series qt62c0h04j, Department of Economics, UC San Diego.
  2. Yiu Chung Cheung & Frank de Jong & Barbara Rindi, 2005. "Trading European sovereign bonds - the microstructure of the MTS trading platforms," Working Paper Series 432, European Central Bank.
  3. Alfonso Dufour & Frank Skinner, 2004. "MTS Time Series: Market and Data Description for the European Bond and Repo Database," ICMA Centre Discussion Papers in Finance icma-dp2004-06, Henley Business School, Reading University.
  4. A. E. Fernández Jilberto, 1991. "Introduction," International Journal of Political Economy, M.E. Sharpe, Inc., vol. 21(1), pages 3-9, April.
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