The information effect of order flows in foreign currency futures and spot markets

• Published date: 01 August 2022
• Author: Yu‐Lun Chen,Yin‐Feng Gau
• Date: 01 August 2022
• DOI: http://doi.org/10.1002/fut.22345

Received: 31 December 2020

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Accepted: 14 May 2022

DOI: 10.1002/fut.22345

RESEARCH ARTICLE

The information effect of order flows in foreign currency

futures and spot markets

Yu‐Lun Chen

1

|Yin‐Feng Gau

2

1

Department of Finance, College of

Business, Chung Yuan Christian

University, Taoyuan, Jhongli, Taiwan

2

Department of Finance, School of

Management, National Central

University, Taoyuan, Taiwan

Correspondence

Yu‐Lun Chen, Department of Finance,

College of Business, Chung Yuan

Christian University, 200 Chung Pei Rd.,

32023 Taoyuan, Jhongli, Taiwan.

Email: yoloom@cycu.edu.tw

Funding information

Ministry of Science and Technology,

Taiwan, Grant/Award Number: MOST

109‐2410‐H‐033‐002‐MY2

Abstract

Using intraday EUR–USD and JPY–USD data in both electronic futures and

spot markets, we examine the important role played by order flow in price

discovery and in intermediating the exchange‐rate reactions to macro-

economic news. We find that, after considering the order flows of futures

and spot markets, the futures market dominates price discovery when

compared with the spot market, confirming that order flows have a permanent

impact on prices, even more so in futures markets. Furthermore, announce-

ment surprises in gross domestic product, jobless claims, and nonfarm payroll

affect both order flows and exchange‐rate changes.

KEYWORDS

foreign exchange, macroeconomic announcement, order flow, price discovery

JEL CLASSIFICATION

F31, G14

1|INTRODUCTION

This paper addresses the information role of foreign exchange (FX) spot and the corresponding futures order

flows on the competition in price discovery. Price discovery is the process by which the market incorporates

information to arrive at the equilibrium price. Many previous studies have documented a positive

contemporaneous relationship between order flow and spot exchange rates (Bacchetta & van Wincoop, 2006;

Berger et al., 2008; Breedon & Vitale, 2010;Cheung&Rime,2014; Evans & Lyons, 2002a,2002b,2008;Evans&

Rime, 2016; Gehrig & Menkhoff, 2004;Love&Payne,2008;Rimeetal.,2010; Rosenberg & Traub, 2009).

1

However, very few studies investigate the cross‐market information content of FX spot and the effect of futures

order flows on the dynamic interaction of these two related markets' prices. To consider the role of order flows

between spot and futures markets in absorbing and conveying information can provide more insight in the FX

price discovery process.

We investigate the price discovery relationship between FX futures and spot markets by jointly considering

returns and order flows in both markets with macroeconomic news announcements, by providing a systematic

analysis on the associations between order flow and returns in the same market, cross‐market returns and order

flow, cross‐market order flows, and cross‐market returns. We further analyze the impact of order flows in both

J Futures Markets. 2022;42:1549–1572. wileyonlinelibrary.com/journal/fut © 2022 Wiley Periodicals LLC.

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Order flow is signed trading volume that is measured by the imbalance between buyer‐initiated and seller‐initiated trading volumes. The positive

contemporaneous relationship indicates that when orders to purchase (sell) a foreign currency exceed orders to sell (purchase), the corresponding

exchange rate rises (falls).

FX futures and spot markets around the release of macroeconomic announcements to examine the information

effect in both markets. To the best of our knowledge, this is the first work investigating the interactive

association between price movements and order flows in both currency spot and futures markets, especially

considering the macronews announcements effect.

The positive contemporaneous link between order flow and exchange‐rate movements could be attributed to the

information or portfolio‐balance (liquidity) effects of order flow on exchange rates (Breedon & Vitale, 2010; Evans &

Lyons, 2002a; Payne, 2003).

2

According to the traditional theory of exchange‐rate determination, under the assumption

of perfect information, exchange rates would be determined by expectations regarding macroeconomic fundamentals,

like, inflation, productivity growth, and interest rates (Rime, 2003). Exchange rates will be efficient asset prices and

announcements of public information are completely impounded into prices. However, the real world allowing for

asymmetric information and heterogeneous agents leaves a role for order flow to convey information (Payne, 2003;

Ranaldo & Somogyi, 2021).

3

The order flow may act as the transmission link between information and exchange rate as

it conveys information, whereby FX dealers can learn from order flow and aggregate price‐relevant information into

currency values (Kleinbrod & Li, 2017).

4

In reality, FX dealers may collect and learn price‐relevant information from order flows in the parallel spot

and futures markets to choose how or which market to trade. As indicated by Rosenberg and Traub (2009), not

only the spot market order flow affects the spot exchange‐rate movements, but the futures market's order flow

also may have an influence on that. In particular, the futures market's order flow can be even more influential

than the spot market order flow in affecting spot rate movements, due to the wide range of market participants

(from hedge funds to spot dealers), anonymity of counterparty identity, and high level of price transparency in

the currency futures market.

Although Rosenberg and Traub (2009) find a strong contemporaneous relation between futures order flows and

spot exchange‐rate changes, we query whether futures order flows convey fundamental information to spot

exchange rate and alter permanently the exchange rate. The contemporaneous relation between futures order

flows and spot exchange‐rate movements may reflect the transient hedging demand, that is, orders to sell

(purchase) in the foreign currency futures to cover exchange‐rate exposure risk, or transient portfolio holding

adjustment. Tornell and Yuan (2012) argue that the influence of futures trading on the spot exchange rate would

be contemporaneous but hardly intertemporal. Payne (2003) separates the information and portfolio‐balance

effects of order flow on exchange rates via a VAR model to isolate the long‐run and short‐run responses of

exchange rate to order flow innovation. The long‐run impact of order flow is interpreted as a measure of

information effect and the short‐run impact is portfolio‐balance effect. In this study we empirically investigate

whether order flows in the FX spot and futures markets would convey fundamental information and have a

permanent impact on both spot and futures exchange rates.

Understanding how order flows across markets carries fundamental‐relevant information is crucial for the analysis of price

discovery in FX spot and futures markets.

5

According to efficient market hypothesis, all available information is fully and

instantaneously utilized to determine the market price; futures prices should move concurrently with their corresponding spot

prices without any lead and lag in price movements from one market to another. However, due to the difference of market

characteristic, such as transaction cost, leverage advantage, level of market transparency, and liquidity, emp irical evidence

shows significantly leading and lagged relationships between currency spot and futures prices (Cabrera et al., 2009;

2

Evans and Lyons (2002a) address that order flow conveys information, in a three‐stage trading process. In Stage 1, dealers trade with the public

(customers) and receive order flows that vary with the levels of information asymmetry, inventory pressure, and hedging demand. In Stage 2, dealers

trade among themselves to share the resulting inventory risk; at the end of this stage, all interdealer order flows are observable by dealers, so they can

aggregate information from order flow made by the public in Stage 1. Finally, in Stage 3, dealers trade again with the public, and the trading prices

reflect information revealed from the interdealer order flows. Payne (2003) separates the information and portfolio‐balance effects of order flow on

exchange rates via a simple vector autoregression (VAR) model. Breedon and Vitale (2010) disentangle the portfolio‐balance and information effects

of order flow on exchange rates based on the direct estimation of a structural model of exchange‐rate determination.

3

Ranaldo and Somogyi (2021) find evidence that order flow impacts FX spot prices heterogeneously across agents, time, and currency pairs,

supporting the asymmetric information hypothesis.

4

Kleinbrod and Li (2017) support that order flow information is gradually incorporated into FX spot prices.

5

Price discovery is the process that fundamental information impounded in market prices and has received substantial attention from academics and

policy maker. Some previous studies explore the role of order flow in price discovery between spot and derivatives markets. Anthony (1988), Chan

et al. (1993), Manaster and Rendleman (1982), Poon (1994), and Sheikh and Ronn (1994) focus on stock and option markets. Pascual et al. (2006)

consider the informativeness of order flows to analyze the price discovery of securities that trade on multiple markets.

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CHEN AND GAU