Under rational expectations and efficient markets, the news contained in public information announcements is directly impounded into prices with there being no role for trades in this process of information assimilation. This paper directly tests this assertion using ten months of transaction level exchange rate data and a sample of scheduled US, UK and Euro-area macroeconomic announcements. The main result of the paper is that even information that is publicly and simultaneously released to all market participants is largely impounded into prices via the key micro-level price determinant -order flow. We quantify the role that order flow plays and find that between a half and two thirds of price relevant information is incorporated into prices via the trading process. * Both authors; Financial Markets Group, London School of Economics and Political Science. Thanks to the Bank of England for providing the transactions data used in this study and to Standard and Poors for providing the expectations data. The paper has also benefitted from comments by Charles Goodhart and Paolo Vitale. All remaining errors are our own.Traditional asset market models of exchange rate determination, based on rational expectations and efficient markets, imply that announcements of public information are directly impounded in prices with there being no role for trades in this process of information assimilation. More recent exchange rate analysis, based on microstructure considerations, stresses the role that trading plays in price formation via a concept called order flow. Order flow is defined to be the difference between buyer-initiated and seller-initiated trading interest in a given market and thus corresponds broadly to what practitioners might describe as aggressive buying or selling pressure. In the models of Lyons (1995), Perraudin and Vitale (1996) and Evans and Lyons (2002b) order flow explains contemporaneous exchange rate movements because it contains information, either about fundamentals or long-run risk premia, that was previously dispersed among market participants. Thus, one of the key differences between the microstructure level analysis and traditional exchange rate frameworks is that the same information is not shared by all market participants and/or is interpreted differently by participants.This paper seeks to test the proposition that public information announcements alter exchange rates with no role for order flow. The test of this hypothesis is direct; using 10 months of transaction-level exchange rate information on USD/EUR (dollars per euro), GBP/EUR (pounds per euro) and USD/GBP (dollars per pound) and data on euro-area, UK and US macroeconomic announcements we examine whether announcement surprises have a systematic and significant effect on both order flow and prices. We also decompose the price reactions to announcements into a part that is direct and a part intermediated by order flow.Our results are unambiguous. At a 1 minute sampling frequency, macroeconomic information releases do have syste...

Order flow has been found to carry information to the market. When assessing how informative order flow is, the VAR methodology is typically employed, using impulse response functions. However, in such analyses, the direction of causality runs explicitly from order flow to asset return. If data are sampled at anything other than at the highest frequencies then any feedback trading may well appear contemporaneous; trading in period t depends on the asset return in that interval. The implications of contemporaneous feedback trading are examined in the spot USD/EUR currency market and we find that when data are sampled at the 1 and 5 minute frequencies, such trading strategies cause the price impact of order flow to be significantly larger than when feedback trading is ruled out. Order flow, one way buying or selling pressure, has a contemporaneous impact on prices, while at the very highest frequencies, the converse is not true. However, when aggregated over time, order flow and prices can be expected to impact on each other simultaneously, a phenomenon we call contemporaneous feedback trading. The existence of contemporaneous feedback trading implies that such models cannot be estimated with traditional techniques. This is unfortunate, since empirical models with feedback trading can be expected to give firmer support for theoretical models than models that ignore such trading strategies. In this paper, we argue that feedback trading is an inevitable consequence of time aggregation of order flow models, and propose an estimator of such models by using instrumental variable techniques. We find that the price impact of trades is much stronger when feedback trading is incorporated, further supporting market microstructure theories generally, and the validity of the order model specifically.It is well known in the theoretical microstructure literature that order flow conveys private information to the market as a whole. In this way, information is aggregated via the trading process implying that order flow has permanent effects on prices. See Kyle (1985), Glosten and Milgrom (1985), Easley andO'Hara (1987), andEvans andLyons (2002b) for examples of such models. These models imply that if trades carry private information then the informativeness of trades can be accessed by their price impact. Furthermore, in empirical models when data are employed at the very highest frequencies, order flow, by definition, can only be affected by the lags of price changes. However, when data are aggregated, transactions and order entry are simultaneous, frustrating empirical investigations.The existence and profitability of feedback trading strategies has been considered in a number of papers. De Long et al. (1990) build a model of feedback trading with rational speculators who will buy (sell) when the price rises (falls). The profitability of a number of feedback trading strategies in stock markets is considered in Jegadeesh and Titman (1993) and the existence of high-frequency positive feedback trading in the US treasury mar...

This paper tries to provide a simple explanation for the empirical finding, documented here and also by Hau, Killeen and Moore (2002), that spreads in the spot USD/EUR market are substantially higher than those in the preceding DEM/USD foreign exchange market. The paper argues that it is primarily the re-factoring of the exchange rate, 1.75 DEM per USD compared to 1 USD per EUR together with the fact that dealers are faced with a minimum tick size, that has caused spreads to increase (as a percentage of mid-quote).

Under rational expectations and efficient markets, the news contained in public information announcements is directly impounded into prices with there being no role for trades in this process of information assimilation. This paper directly tests this assertion using ten months of transaction level exchange rate data and a sample of scheduled US, UK and Euro-area macroeconomic announcements. The main result of the paper is that even information that is publicly and simultaneously released to all market participants is largely impounded into prices via the key micro-level price determinant -order flow. We quantify the role that order flow plays and find that between a half and two thirds of price relevant information is incorporated into prices via the trading process. * Both authors; Financial Markets Group, London School of Economics and Political Science. Thanks to the Bank of England for providing the transactions data used in this study and to Standard and Poors for providing the expectations data. The paper has also benefitted from comments by Charles Goodhart and Paolo Vitale. All remaining errors are our own.Traditional asset market models of exchange rate determination, based on rational expectations and efficient markets, imply that announcements of public information are directly impounded in prices with there being no role for trades in this process of information assimilation. More recent exchange rate analysis, based on microstructure considerations, stresses the role that trading plays in price formation via a concept called order flow. Order flow is defined to be the difference between buyer-initiated and seller-initiated trading interest in a given market and thus corresponds broadly to what practitioners might describe as aggressive buying or selling pressure. In the models of Lyons (1995), Perraudin and Vitale (1996) and Evans and Lyons (2002b) order flow explains contemporaneous exchange rate movements because it contains information, either about fundamentals or long-run risk premia, that was previously dispersed among market participants. Thus, one of the key differences between the microstructure level analysis and traditional exchange rate frameworks is that the same information is not shared by all market participants and/or is interpreted differently by participants.This paper seeks to test the proposition that public information announcements alter exchange rates with no role for order flow. The test of this hypothesis is direct; using 10 months of transaction-level exchange rate information on USD/EUR (dollars per euro), GBP/EUR (pounds per euro) and USD/GBP (dollars per pound) and data on euro-area, UK and US macroeconomic announcements we examine whether announcement surprises have a systematic and significant effect on both order flow and prices. We also decompose the price reactions to announcements into a part that is direct and a part intermediated by order flow.Our results are unambiguous. At a 1 minute sampling frequency, macroeconomic information releases do have syste...