Abstract
AbstractDo market participants look into the past whilst framing the trading decisions today? Microstructure theory shows that participants increase bid‐ask spreads in response to macroeconomic news to account for asymmetric information and inventory costs. However, the role of perceptions or biases of the market participants in influencing the bid‐ask spread has been largely overlooked. This paper incorporates the role of ‘Recurrence bias’ in influencing trading decisions and therefore market volatility. Empirically, the model is tested using high‐frequency exchange rate data and time‐stamped news data on Indian rupee, which has seen sharp volatility in the period under study. Logit and GARCH analysis shows that volatility is positively linked to ‘Recurrence Bias’, which arises from the ‘availability of mental models’ to traders, created by past response of exchange rate to unexpected component of news.
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