Volume and volatility in foreign exchange market microstructure: a Markov switching approach

Rim Khemiri

Applied Financial Economics, 2012, vol. 22, issue 14, 1121-1133

Abstract: This article has two aims. First, I revisit Khemiri (2009) and I find support to Lyons (1995) seminal dealer level specification with a still richer picture of the conditional volatility dynamics. For this reason, I develop an estimation procedure for a variety of Generalized Autoregressive Conditional Heteroscedasticity (GARCH) and Markov Switching Exponential GARCH (MSGARCH) models which provide a richer modelling of volatility dynamics and I find that the Markov Switching Exponential GARCH (MSEGARCH) model fits the intraday data better. In addition, the second aim of this article is to study the relationship between trading volume and volatility in the Foreign Exchange (FX) market microstructure by using a Markov switching approach that captures asymmetry and regime shifts in the Lyons (1995) dataset. In this context, the empirical results support the Mixture of Distribution Hypothesis (MDH) where I find a new result showing that that there is a positive correlation between volume and volatility of the Deutsche Mark (DM)/$ prices as well as a positive effect of order flow on returns. This confirms the role of order flow as a mean of transmission of information in the new microexchange rate economics.

Date: 2012
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DOI: 10.1080/09603107.2011.629979

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