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A Structural Error-Correction Model of Best Prices and Depths in the Foreign Exchange Limit Order Market

Author

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  • Ingrid Lo
  • Stephen Sapp

Abstract

Traders using the electronic limit order book in the foreign exchange market can watch the posted price and depth of the best quotes change over the day. The authors use a structural errorcorrection model to examine the dynamics of the relationship between the best bid price, the best ask price, and their associated depths. They incorporate measures of the market depth behind the best quotes as regressors. They report four main findings. First, best prices and their associated depths are contemporaneously related to each other. More specifically, an increase in the ask (bid) price is associated with a drop (rise) in the ask (bid) depth. This suggests that sell traders avoid the adverse-selection risk of selling in a rising market. Second, when the spread-the error-correction term-widens, the bid price rises and the ask price drops, returning the spread to its long-term equilibrium value. Further, the best depth on both sides of the market drops, due to increased market uncertainty. Third, the lagged best depth impacts the price discovery on both sides of the market, with the effect being strongest on the same side of the market. Fourth, changes in the depth behind the best quotes impact both the best prices and quantities, even though those changes are unobservable to market participants.

Suggested Citation

  • Ingrid Lo & Stephen Sapp, 2006. "A Structural Error-Correction Model of Best Prices and Depths in the Foreign Exchange Limit Order Market," Staff Working Papers 06-8, Bank of Canada.
    • Handle: RePEc:bca:bocawp:06-8
    DOI: 10.34989/swp-2006-8
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    References listed on IDEAS

    as
    1. Alfonso Dufour & Robert F. Engle, 2000. "Time and the Price Impact of a Trade," Journal of Finance, American Finance Association, vol. 55(6), pages 2467-2498, December.
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    Cited by:

    1. Hautsch, Nikolaus & Huang, Ruihong, 2012. "The market impact of a limit order," Journal of Economic Dynamics and Control, Elsevier, vol. 36(4), pages 501-522.
    2. Partha Chatterjee & Malik Shukayev, 2006. "Are Average Growth Rate and Volatility Related?," Staff Working Papers 06-24, Bank of Canada.

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    More about this item

    Keywords

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    JEL classification:

    • C3 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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