Forecasting exchange rate returns and transaction costs : 125.899 thesis
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Date
2014
DOI
Open Access Location
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Massey University
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Abstract
Order flow in interdealer FX markets is driven by large banks, which are viewed as
more informed (Bjønnes, Osler & Rime, 2011). Order flow is a key determinant of
exchange rates and bid-ask spreads, because order flow conveys information that is
assumed to be related to future exchange rate fundamentals. Thus, the impact of
order flow on exchange rates is persistent at short to medium horizons regardless of
the source of exchange rate fluctuation, because agents (i.e. dealers) rationally
interpret the resulting exchange rate movement as information about future
exchange rate fundamentals. The persistent impact of order flow on exchange rates
and bid-ask spreads implies that order flow should provide forecasting power for
both future exchange rates and future bid-ask spreads.
This also implies that order flow specification should improve returns, forecasting
accuracy and performance stability under market volatility relative to naïve
forecasting models. This is due to the order flow model being based on information
about future exchange rate fundamentals, whereas naïve forecasting models are
only based on information about either past or present information on exchange rate
fundamentals.
This paper examines the forecasting ability of order flow for both future exchange
rates and future bid-ask spreads, using 13 currency pairs that include the heavily
traded Euro, the Great Britain pound and the Australian dollar. This paper then
evaluates returns, forecasting accuracy and performance stability under market
volatility by comparing the results of the order flow model with those of three
alternative naïve forecasting models: (1) A buy-and-hold strategy; (2) a naïve random
walk model; and (3) a moving average model. This paper shows that order flow has
superior forecasting ability in terms of generating higher returns, lower bid-ask
spreads, and producing more stable and less volatile performance. In addition, this
paper also provides evidence of an intraday pattern of bid-ask spreads that suggests
periods at which bid-ask spreads are narrower, during which trading costs can be
minimised.
Description
Raw data and program files available with hard copy in the library
Keywords
Foreign exchange futures, Mathematical models, Transaction costs, Research Subject Categories::SOCIAL SCIENCES::Business and economics