Order Book Commonalities and Bond Return Predictability

Abstract

We examine the commonalities in the limit order book and the return predictive power of the order book information. Our analysis focuses on the transaction data that contains most actively traded Euro-area sovereign bonds on the MTS electronic platform and covers the period from Apr 1 to Sep 30, 2003. We evaluate the trading values of limit orders and use the option-based order book asymmetries to characterize the state of the limit order book. Our empirical finding suggest that a significant portion of the individual book asymmetry can be explained by common factors in the limit order book. More importantly, the common factors in the order book and the individual book asymmetry could significantly predict the future variations of bond returns. The long-term predictive power of the order book asymmetries is significant for up to 55 percent of the bonds in the sample. Evaluating the out-of-sample performance, we show that our forecasting model outperforms the benchmark in the accuracy of the return forecasts.