Volume or Order Flow? : Which contains more information in really traded Yen/Dollar Foreign Exchange Market?

Masayuki Susai (Nagasaki University)

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Model

So many researches are trying to explore the impact of information arrival on asset price movement. Some are using stock data, others are using FX data. In former case, trading volume is employed as the proxy of information arrival. But in the latter, only the quote intensity or representative volume is used as the proxy of information arrival. In this paper, we use trading volume in each transaction.

One of the approaches for this subject is based on the mixture of distribution hypothesis (MDH). This hypothesis stems from the research done by Clark (1973). If foreign exchange rate move randomly and the number of the jump of this rate is positively related to the number of information arrival, the volatility of this rate in a given time interval may increase with the number of information arrival to this market.

In line with this hypothesis, the relation between price volatility and trading volume is explored. Lamoureux and Lastrapes (1990) were introducing volume data into conditional variance equation of GARCH model to test MDH and found that GARCH effect fade away with volume data. Because this outcome was very clear, so many researchers have been trying to test MDH with the method proposed by Lamoureux and Lastrapes (1990).

Bauwens, Rime and Sucarrat (2006) were testing MDH directly. Like other studies, they used quote intensity as the proxy of trading volume of Norwegian Krone and found significant impact of information arrival on foreign exchange volatility. They also estimate same kind of model as the model in Lamoureux and Lastrapes (1990), they did not mention anything about the estimation result in conditional variance terms.

In this paper, our main objectives is that we try to explore the impact of information arrival on foreign exchange rate volatility in line with MDH, we take up the methods proposed by Bauwens, Rime and Sucarrat (2006) and Lamoureux and Lastrapes (1990). In Bauwens, Rime and Sucarrat (2006), they employ OLS and EGARCH. But we do not use both because the estimation result from OLS is not same and we do not think EGARCH is good model for foreign exchange rate from conceptual reason . So, we choose GARCH (1,1) as basic model to describe foreign exchange movement.

At the same time, we test the effect of order flow on foreign exchange rate volatility. A series of researches of Evans and Lyons are investigating the role of the order flow in foreign exchange market and find that order flow is one of the important elements which have strong effect on the movement of foreign exchange rate. In this paper, we use the proxy of order flow to explore the impact in our setting.

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