Abstract
Financial prices fluctuate as a results of the market impact of the flow of transactions between traders. Reciprocally, several studies of market microstructure have shown how decisions of individual traders or banks, implemented in their trading strategies, are affected by historical market information. However, little is known about the detailed processes of how such trading strategies at the micro level recursively affect future market information at the macro level. Using a special fined-grained dataset that allows us to track the complete trading behavior of specific banks in a U.S. dollar (USD) versus Japanese yen (JPY) market, we find that position management methods, defined as the number of units of USD bought or sold by banks against JPY, can be classified into two strategies: (1) banks increase their positions by trading in the same direction repeatedly, or (2) banks attempt to reduce their inventories by rapidly shifting their positions toward zero. We then demonstrate that their systematic position management strategies strongly influence future market prices, as demonstrated by our ability using this information to predict market prices about fifteen minutes in advance. Further, by detecting outlier trades, we reveal that traders seem to switch their strategies when they become aware of outlier trades. The evidence obtained here suggests that positions, which are a consequence of historical trading decisions based on the position management strategies of each bank, strongly influence future market prices, and we unravel how market prices at the macro level evolve through an interactive process involving the interaction between well-defined trading strategies at the micro level.
Highlights
In subsections 4.3 and 4.4, we characterize the position management strategies as well as the outlier trades against marketprice behavior, especially those observed around trading decisions
By tracking currency positions representing a detailed history of trading decisions, we classified position management strategies into two classes, namely, economically-motivated (EM) and arbitrage-motivated (AM) strategies, according to the response patterns to position fluctuations
We showed that the banks following a third “market maker” (MM) strategy, defined as the strategy for banks that do not fall in either the AM or EM classes, somehow detect outlier trades using historical market information and change their strategies to jack up limit-order prices in anticipation of the subsequent transaction on the same side
Summary
Contrary to the old traditional theoretical assumption that traders are rational and have homogeneous expectations regarding future market prices [1, 2], a number of empirical studies have revealed their heterogeneity at various levels by tracking individual trading behavior [3,4,5,6,7,8,9,10,11]. Classification of position management strategies enable future market-price prediction
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