Academic journal article Journal of Economic Cooperation & Development

Bid-Ask Spread, Futures Market Sentiment and Exchange Rate Returns

Academic journal article Journal of Economic Cooperation & Development

Bid-Ask Spread, Futures Market Sentiment and Exchange Rate Returns

Article excerpt

This paper analyzes spot foreign exchange bid-ask spread and the future market sentiment as two important variables to explain the exchange rate returns. We use two sentiment indices based on futures market return and volume. Time series and cross-sectional analyses of three different currency exchange rates; Australian Dollar, British Pound and Canadian Dollar - to US Dollar suggest that the spot market bid-ask spread is one important variable that positively affects the spot exchange rate returns. The return based sentiment index does not seem to be a significant factor, but the volume based sentiment index affects the spot exchange rate returns significantly. The negative sign of sentiment indices implies lower spot market return associated with higher investor interest in futures market, although higher trading in futures market contributes positively in the spot market.

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1. Introduction

Literature on foreign exchange focuses on understanding the exchange rate dynamics both in short and long horizons. Prior researches use both macro- and micro-based models in order to explain the exchange rate return fundamentals. Macro-based models associate macroeconomic variables, e.g., relative money supplies, outputs, inflation and interest rates, with exchange rates (Engel and West, 2005; Groen, 2000; Clarida,

Gali and Gertler, 1998). Empirical macro-based researches test the direct impact of both expected and unexpected macroeconomic news on exchange rate return (Evans and Lyons, 2008; Anderson et. al., 2003). These models pay a little attention on the trading mechanism in the foreign exchange market. On the other hand, micro-based models test how pricing information are reflected in the exchange rate through the trading process by analyzing the order flow in the foreign exchange market (Evans and Lyons, 2005b, 2002).

Like the spot foreign exchange market, the price discovery in foreign exchange futures market is also important. Tse, Xiang, and Fung (2006) argue that futures market provides both public and private information held by various economic agents. They also show that futures contracts provide the most price discovery for euro. Chen and Gau (2010) analyze the competition in price discovery between spot and futures markets for the euro and Japanese yen and find that the spot rates, on average, provide more price discovery than the futures rates; but the futures rates contribute more to price discovery during macroeconomic announcement releases.

In this paper we analyze this issue from a different direction by focusing on the contribution of spot market bid-ask spread and futures market sentiment on the price discovery in the spot foreign exchange market. Researchers (Evans and Lyons, 2007, 2005a, 2005b, 2002; Cerrato, Sarantis and Saunders, 2011) consider order flow as an important factor that can explain the exchange rate returns. But these studies do not focus on the bid-ask spread (spread) - another important factor in foreign exchange market. On the other hand, liquidity plays an important role in foreign exchange market. Amihud (2002) suggests that spread partly represent the illiquidity premium on the expected stock return. In this light Chen, Chien and Chang (2012) suggest that liquidity providers in the market supply liquidity at a cost - the spread. They find order flow the main explanatory variable for active currencies, but the spread is a potential candidate in explaining the daily returns on infrequently traded currencies. For this, this paper uses spread as one important factor explaining the spot foreign exchange returns.

In this paper, we also analyze foreign exchange futures market sentiment as another important factor that explains the spot exchange rate returns. A number of papers examine futures market effect on the spot market. Board, Sandmann and Sutcliffe (2001) analyze the futures market volume on spot market volatilities. …

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