Exchange Rate Economics: Theories and Evidence

Market microstructure approach 359
the actual transactions prices culled from the 2000–2 with the indicative bid–ask
quotes contained on the Reuters FXFX page. They find that the levels of the two
prices (i.e. average of bid–ask) have very similar properties but that the behaviour
of the touch from the 2000–2 is very different from the bid–ask spread derived
from the FXFX,and so using the latter would give a very poor indication of how
market spreads evolve over time.
In their study,referred to earlier,Cheung and Chinn (1999) show that traders
have a range of what they regard as conventional bid–ask spreads – five basis points
for the Swiss franc and UK pound against the US dollar and three basis points for
the German mark and Japanese yen against the US dollar and in practice they find
that only a small proportion of bid–ask spreads deviate from the convention. They
note that the most popular reason for adopting the conventional spread is to ‘maintain
an equitable and reciprocal trading relationship’,since offering quotes with a
conventional spread is one of the key ways a trader can establish his reputation.
Of those dealers who do deviate from the convention the majority offer narrower
spreads and this is because some professional dealers like to demonstrate to customers
they are able to bear greater risk by offering a tighter price. The most cited
reason for deviating from the conventional spread and increasing the spread is a
‘thin and hectic market’ which is seen as reflecting increased volatility and uncertainty.
For example,43% of the responses claimed ‘increased market volatility’,
before/after a major news release and ‘unexpected change in market activity’ as
the main driving forces of uncertainty. This kind of result seems to match the
results of Jorion (1996) that there is a correlation between volatility and bid–ask
spreads. Trading profits turn out to play only a minor role in setting spreads and
this is because dealers make most of their money on rate changes rather than from
the spread itself.
Cheung and Chinn (1999) also find that the DM/USD and Yen/USD markets
are fairly competitive in terms of the make up of the players. However,
the smaller dollar–pound and Swiss franc markets are much more dominated
by the larger banks. The large players are perceived by the survey respondents
to have a better customer and market network which give them better information
on order flow and the activity of other trading banks. This would seem
to reinforce Lyons’ (1997) view that order flow can be used to explain trading
volume.
14.4.3 Order flow – how does it affect price?
Perhaps the key variable in the microstructural approach is order flow,which is the
conduit through which the actions and interactions of individuals is revealed. It is
Lyons’ second hallmark of the microstructural approach. Order flow is transaction
volume that is signed. That is,if an agent approaches a bank dealer and buys (sells)
1000 euros,the transaction volume is 1000 and the order flow +1000 (−1000).
Summing the order flow over time indicates if there has been net selling (negative
sum) or net buying (positive sum) over a period. In terms of a broker order,flow
has a slightly different interpretation since they,as we have seen,have a limit order