Abstract
We extend the ‘portfolio shifts’ model of Evans and Lyons (2002) to allow FX dealers to use both limit and market orders in order to exploit private information in inter-dealer trading. Both market and limit orders contain information on customer-dealer flows. Consequently, equilibrium exchange rates depend on both types of order flows. Limit orders have lower price impact than market orders because they do not have to be absorbed by ultimate customers. We test these predictions using 2 years data for GBP/USD, EUR/USD and EUR/GBP from an order-driven inter-dealer FX trading venue. Our empirical analysis gives strong support to the predictions of the model at macroeconomically relevant sampling frequencies. Empirically, the price impact of market order flows is substantially increased by the inclusion of limit orders in the regression indicating that the omission of a relevant explanatory variable seriously understates the importance of the Evans-Lyons result.
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