Order flow, bid–ask spread and trading density in foreign exchange markets

Shikuan Chen, Chih Chien and Ming-Jen Chang

Journal of Banking & Finance, 2012, vol. 36, issue 2, 597-612

Abstract: This paper examines the implications of market microstructure for foreign exchange markets. We argue that the usual order flow model needs to be recast in broader terms to incorporate the transaction costs of liquidity and the limitation of price discovery through order flows that involve low trading density currencies. Using a daily data set, we find that order flows are inadequate when it comes to explaining the changes in the low trading density currencies. Alternatively, within the high trading density, both order flows and bid–ask spreads significantly affect the foreign exchange rate returns. Our findings suggest that the order flow model is better at incorporating these microstructure effects except for some currencies with a very high level of trading density.

Keywords: Bid–ask spread; Foreign exchange markets; Liquidity; Microstructure effects; Order flow; Trading density (search for similar items in EconPapers)
JEL-codes: F31 G12 (search for similar items in EconPapers)
Date: 2012
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Citations: View citations in EconPapers (4)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:36:y:2012:i:2:p:597-612

DOI: 10.1016/j.jbankfin.2011.09.006

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