Spot Foreign Exchange Research Articles

Interactions of Spot Foreign Exchange Markets among Taiwan, Hong Kong and Japan: Japanese Forward Premium/Discount as an Information Variable

Interactions of Spot Foreign Exchange Markets among Taiwan, Hong Kong and Japan: Japanese Forward Premium/Discount as an Information Variable

The price discovery in the renminbi/USD market: Two spot, two swap, and three forward FX rates

This paper employs the vector error correction model (VECM) to measure the contribution of the onshore renminbi spot foreign exchange (CNY) rate to the price discovery of the offshore one (CNH). The VECM incorporates the covered interest rate parity condition by introducing the forward swap rate. Each rate has onshore and offshore markets, and the VECM encompasses the seven variables. This rich VECM challenges the small VECM with only two CNH and CNY rates, revealing an overstatement of the CNH's contribution. Additionally, CNY and CNH are the main contributors to the price discovery of the forward exchange rates. When the central parity is set to be weaker than the previous day's closing of the CNY, the CNY is dominant over the CNH in terms of the information share in the spot FX rate. This effect is amplified after the month of sluggish Chinese exports.

What Makes HFTs Tick? Tick Size Changes and Information Advantage in a Market with Fast and Slow Traders

We study the impact of two changes in the minimum tick size, a reduction and a subsequent increase, on the trading behavior of fast and slow traders in the spot foreign exchange market. We find that the most notable impact of the tick size reduction is a substantial increase in the liquidity demand of high-frequency traders (HFTs) and not the decrease in their liquidity provision discussed by prior literature. We show that this change in behavior is linked to the higher frequency of price signals that arises with the smaller tick size and to the ability of fast traders to profit from it, often at the detriment of slower traders. Following the tick size decrease and the increase in liquidity demand by HFTs in the spot market, the role of the spot market in price discovery drops relative to that of the futures market. We discuss these findings in the context of the impact of HFTs on the information content of financial markets. This paper was accepted by Agostino Capponi, finance. Supplemental Material: The data files are available at https://doi.org/10.1287/mnsc.2022.02935 .

Multi-regime foreign exchange rate model: Calibration and pricing

To price exotic foreign exchange (FX) options, a model needs to be selected for FX spot rate dynamics. The classic approach of modelling spot rates with Black–Scholes framework makes inappropriate assumptions of constant drift and volatility, resulting in mispricing. In this article, we investigate multi-regime Black–Scholes (MRBS) model for FX rate, with regime-switching behaviour of drift and volatility governed by a Markov chain. We derive an analytic formula for European FX call options via Fourier transform and present a Monte Carlo simulation algorithm for FX barrier option pricing. Further, we propose a calibration strategy with penalty. Finally, the empirical study shows that volatility smile can be recovered by MRBS model; calibrating MRBS with penalty gives stable calibrated parameters and small out-of-sample mean squared errors; combined use of our calibration methods and pricing algorithms provides reasonable prices for FX barrier options. Thus, MRBS model, together with proposed calibration-with-penalty strategy and pricing algorithm, provides a promising approach for FX option pricing.

Exploring New Trends in the Global Foreign Exchange Derivatives Market Based on the European and American Financial Markets

This research delves into the changes in products and participants in the foreign exchange derivatives market in Europe and America. It uncovers the new trends in the global foreign exchange derivatives market. The European and American financial markets are significant players in foreign exchange trading and financial innovation, as they affect the world through their market fluctuations and policy changes. The study reveals that the foreign exchange derivatives market is undergoing new dynamics and environmental changes. Innovative products are emerging, and the level of transaction automation is increasing. The foreign exchange derivatives market in Europe and the United States has transformed from a simple spot foreign exchange transaction to a diverse trading system that covers major global currencies. The proportion structure of trading participants is also changing over time. In conclusion, this research provides profound insights into the global foreign exchange derivatives market. It aims to provide relevant suggestions and references for market participants and regulators based on its analysis.

Foreign exchange hedging using regime‐switching models: The case of pound sterling

AbstractWe develop a four‐state regime‐switching model for optimal foreign exchange (FX) hedging using forward contracts. The states correspond to four distinct market conditions, each defined by the direction and magnitude of deviation of the prevailing FX spot rate from its long‐term trends. The model's performance is evaluated for five currencies against the pound sterling for various horizons. Our examination compares the hedging outcomes of the proposed model to those of other commonly employed hedging methods. The empirical results suggest that our model demonstrates the highest level of risk reduction for the US dollar, euro, Japanese yen and Turkish lira and the second‐best performance for the Indian rupee. The risk reduction is significantly higher for lira compared with the other approaches, implying that the proposed model might be able to provide much more effective hedging for highly volatile currencies. The improved performance of the model can be attributed to the adjustability of the estimation horizon for the optimal hedge ratio based on the prevailing market conditions. This, in turn, allows it to better capture fat‐tail properties that are frequently observed in FX returns. Our findings suggest that FX investors tend to use short‐term memory during low market conditions (relative to trend) and long‐term memory in high ones. The results would be also useful to build a better understanding of how investor behaviour depends on market conditions and mitigate the adverse behavioural implications of short‐term memory, such as panic.

Cross-market spoofing

Since 2012, regulatory investigations have revealed widespread manipulation and collusive practices among banks active in over-the-counter (OTC) markets. These discoveries have resulted in fines and settlements amounting to billions of US dollars, criminal proceedings and stricter regulation worldwide. However, recent legal cases and regulatory reports indicate that authorities have stepped up their efforts to crack down on so-called “cross-market spoofing”. The manipulative tactic involves a combination of a genuine order in one market and a spoof order in another, which is notoriously difficult to detect. In this paper, we use a high-frequency data set of limit order book snapshots from the foreign exchange (FX) spot market to develop and test a methodology to assess the feasibility, and hence potential prevalence, of cross-market spoofing. Our findings show that predictable reactions follow potential single-market spoofs that a market manipulator may exploit. Crucially, we also find that predictability may be observed in closely related markets. In particular, we discover that EUR/JPY offers a reliable pathway for a manipulator to exploit via spoof orders at deeper levels in the EUR/USD or USD/JPY limit order books. The findings suggest that a manipulator is more likely to submit a spoof order in a liquid market and a resting order in a less liquid but closely related market, rather than vice versa. Moreover, cross-market spoof orders are more likely to be found in markets that act as hedging markets.

Trade friction and price discovery in the USD–CAD spot and forward markets

This paper examines the impact of trade friction on price discovery in the USD–CAD spot and forward markets. Using the recently developed fractionally cointegrated vector autoregressive (FCVAR) model, we investigate how the foreign exchange spot and forward markets respond to trade friction. We consider two major trade friction events: the United States–Mexico–Canada Agreement and the recent trade friction between Canada and China. Both events show that the forward market plays a dominant role in price discovery, and the influence of the forward market increases as trade tension increases. By comparing the fractional and non-fractional models, we find that the fractional model fits the data better and has superior forecasting performance to the cointegrated vector autoregressive (CVAR) model.

Foreign exchange markets: Price response and spread impact

We carry out a detailed large-scale data analysis of price response functions in the spot foreign exchange market for different years and different time scales. Such response functions provide quantitative information on the deviation from Markovian behavior. The price response functions show an increase to a maximum followed by a slow decrease as the time lag grows, in trade time scale and in physical time scale, for all analyzed years. Furthermore, we use a price increment point (pip) bid–ask spread definition to group different foreign exchange pairs and analyze the impact of the bid–ask spread in the price response functions. We find that large pip bid–ask spreads have a stronger impact on the response. This is similar to what has been found in stock markets.

FX spot and swap market liquidity spillovers

We study the joint evolution of foreign exchange (FX) spot and swap market liquidity. We find strong co-movement in spot and swap market liquidity conditions and a robust link between FX funding and market liquidity, as gleaned from the pricing of both instruments. This link has strengthened over time. Dealing desks of globally systemically important banks periodically pull back from pricing FX swaps, particularly those that operate closer to regulatory capital or liquidity minimums. While wider spreads attract smaller dealers, liquidity in FX swaps remains impaired, which leads to illiquidity spillovers to the spot market. Our findings suggest that funding liquidity has become a more important driver of spot market liquidity than it used to be.

Foreign exchange option pricing under regime switching with asymmetrical jumps

In this study, we investigate the valuation of foreign exchange (FX) options by identifying a two-factor Markov-modulated stochastic volatility model with double exponential jumps to capture long- and short-term stochastic volatility and asymmetrical jumps in the underlying spot FX rate. Furthermore, the dynamics of domestic/foreign instantaneous forward interest rates are governed by a Markov-modulated Heath-Jarrow-Morton model. The dynamic measure change technique is employed to determine a pricing kernel for deriving the FX option pricing formula. Finally, numerical illustrations are provided and analyzed.

Jumps in foreign exchange spot rates and the informational efficiency of currency forwards

AbstractIn this paper, we show that forward premiums are significant predictors of innovations in currency spot rates, and currency forward rates lead to price discovery during normal trading periods. Conversely, currency spot rates lead to price discovery during volatile periods. This finding is linked to investors' overreaction to information, which in turn induces jumps in the currency spot rate; positive jumps weaken the contribution of the forward rate to price discovery and their informational efficiency. We also find that the forward premium puzzle is linked to jump‐driven pricing inefficiencies.

Scale-, time- and asset-dependence of Hawkes process estimates on high frequency price changes

The statistical estimate of the branching ratio η of the Hawkes model, when fitted to windows of mid-price changes, has been reported to approach criticality () as the fitting window becomes large. In this study – using price changes from the EUR/USD currency pair traded on the Electronic Broking Services (EBS) interbank trading platform and the S&P 500 E-mini futures contract traded at the Chicago Mercantile Exchange (CME) – it is shown that the estimated branching ratio depends little upon window size and is usually far from criticality. This is done by controlling for exogenous non-stationarities/heterogeneities at inter- and intraday scales, accomplished by using information criteria to select the degree of flexibility of the Hawkes immigration intensity, either piecewise constant or adaptive logspline, estimated using an expectation maximization (EM) algorithm. The (positive) bias incurred by keeping the immigration intensity constant is small for time scales up to two hours, but can become as high as 0.3 for windows spanning days. This emphasizes the importance of choosing an appropriate model for the immigration intensity in the application of Hawkes processes to financial data and elsewhere. The branching ratio is also found to have an intraday seasonality, where it appears to be higher during times where market activity is dominated by supposedly reflexive automated decisions and a lack of fundamental news and trading. The insights into the microstructure of the two considered markets derived from our Hawkes process fits suggest that equity futures exhibit more complex non-stationary features, are more endogenous, persistent and traded at higher speed than spot foreign exchange. We complement our point process study with EM-estimates of integer-valued autoregressive (INAR) time series models at even longer scales of months. Transferring our methodologies to the aggregate bin-count setting confirms that, even at these very long scales, criticality can be rejected.

Price Discovery Vehicle in Foreign Exchange Spot & Future Market- The Evidence from National Stock Exchange

The study is aimed at examining the price discovery (lead-lag) relationship between spot & future market for four currencies i.e., USD, EURO, GBP, JPY in context of INR. The estimation of relationship is executed in three steps. First, to unfold the time series properties & the order of integration Unit Root Test (Augmented Dickey-Fuller) is applied to check the stationarity of the data. Second, to explore the nature (long-run or short-run) of relationship cointegration tests (Engel and Granger’s residual-based approach and Johansen’s cointegration test) are applied. Third, Vector Error Correction Model (VECM) is carried out to determine the leading market. The study covered the sample period from November 1st, 2013 to March 29th, 2016.The findings elucidate that spot return exhibits adjustment tendencies & the futures market impounds information faster than the spot market. It implies that future market leads the spot market for each currency.

Spoofing and pinging in foreign exchange markets

This paper investigates the susceptibility of foreign exchange (FX) spot markets to limit order submission strategies that are either intended to create a false impression of the state of the market (‘spoof orders’) or to extract hidden information from the market (‘ping orders’). Using a complete limit order book dataset from Electronic Broking Services (EBS), our findings suggest that spoofing is more likely to succeed in liquid markets, or on primary electronic trading platforms. Pinging, by contrast, might be more prevalent in illiquid markets, or on secondary electronic trading platforms.

Counterparty Credit Limits: The Impact of a Risk-Mitigation Measure on Everyday Trading

ABSTRACT A counterparty credit limit (CCL) is a limit that is imposed by a financial institution to cap its maximum possible exposure to a specified counterparty. CCLs help institutions to mitigate counterparty credit risk via selective diversification of their exposures. In this paper, we analyse how CCLs impact the prices that institutions pay for their trades during everyday trading. We study a high-quality data set from a large electronic trading platform in the foreign exchange spot market that allows institutions to apply CCLs. We find empirically that CCLs had little impact on the vast majority of trades in this data set. We also study the impact of CCLs using a new model of trading. By simulating our model with different underlying CCL networks, we highlight that CCLs can have a major impact in some situations.

Foreign Currency Power Option Pricing Based on Esscher Transform

In this paper, we introduce a dynamic model for the spot foreign exchange rate which is driven by a standard Brownian motion and a stationary compound Poisson process under the domestic real measure. In order to price the derivatives on the foreign exchange rate, we need to find an equivalent probability measure under which the discounted process of the foreign exchange rate by the domestic free interest rate minus the foreign free interest rate is a martingale. The Esscher transform is an efficient technique to find an equivalent martingale measure. Applying the tool of the characteristic function, we derive some Esscher transform parameters with respect to the spot foreign exchange rate. At the same time, we get the corresponding Esscher martingale measure which is the domestic risk-neutral measure Q equivalent to the domestic real measure. Moreover, we reconsider the dynamic process of the spot foreign exchange rate under the measure Q. Furthermore, we hope that the exchange rate fluctuates within a certain range, since too large fluctuation will bring a series of serious problems. In fact, the foreign exchange rate is usually stable in a certain range. Thus, studying the pricing of foreign exchange rate derivatives, we often assume that the foreign exchange rate fluctuates within a certain range. Based on the above work, we combine European option with the power option to propose a new type of the foreign exchange power option whose payoff function is controlled by multiplying an indicative function on the interval of the foreign exchange rate and further obtain the pricing formulas under this model. At last, we utilize the actual market data of the foreign exchange rate of USD/CNY to obtain the value of the foreign exchange power option and investigate the implied volatility.

Scale-, time- and asset-dependence of Hawkes process estimates on high frequency price changes

The statistical estimate of the branching ratio η of the Hawkes model, when fitted to windows of mid-price changes, has been reported to approach criticality (η = 1) as the fitting window becomes large. In this study -- using price changes from the EUR/USD currency pair traded on the Electronic Broking Services (EBS) interbank trading platform and the S&P 500 E-mini futures contract traded at the Chicago Mercantile Exchange (CME) -- it is shown that the estimated branching ratio depends little upon window size and is usually far from criticality. This is done by controlling for exogenous non-stationarities/heterogeneities at inter- and intraday scales, accomplished by using information criteria to select the degree of flexibility of the Hawkes immigration intensity, either piecewise constant or adaptive logspline, estimated using an expectation maximization (EM) algorithm. The bias incurred by keeping the immigration intensity constant is small for time scales up to two hours, but can become as high as 0.3 for windows spanning days. This emphasizes the importance of choosing an appropriate model for the immigration intensity in the application of Hawkes processes to financial data and elsewhere. The branching ratio is also found to have an intraday seasonality, where it appears to be higher during times where market activity is dominated by supposedly reflexive automated decisions and a lack of fundamental news and trading. The insights into the microstructure of the two considered markets derived from our Hawkes process fits suggest that equity futures exhibit more complex non-stationary features, are more endogenous, persistent and traded at higher speed than spot foreign exchange. We complement our point process study with EM-estimates of integer-valued autoregressive (INAR) time series models at even longer scales of months. Transferring our methodologies to the aggregate bin-count setting confirms that even at these very long scales, criticality can be rejected.

A Study on the Efficiency of the Foreign Exchange Markets: Evidence from Korea, Japan and China

Purpose - The purpose of this study was to examine the efficiency of the foreign exchange markets in Korea, Japan and China. Design/methodology/approach - This study collected 1327 observations each of the daily closing exchange rates of the three currencies against the US dollar for the sample period from January 1, 2015 to January 31, 2020, based on the tests for autocorrelation, unit root tests and GARCH-M(1,1) model estimation. Findings - We have found that the autocorrelation test indicates the lack of autocorrelation and unit root test confirms the existence of unit roots in all times series of the three currencies, respectively. The GARCH-M(1,1) test results, however, suggest that the exchange rates do not follow a random walk process. In conclusion, the recent spot foreign exchange markets in Korea, Japan and China are believed to be informationally inefficient. Research implications or Originality - These findings have practical implications for both individual and institutional investors to be able to obtain excess returns on their investments in the foreign exchange markets in three countries by using appropriate risk management, portfolio strategy, technical analysis, etc. This study provides the first empirical examination on the foreign exchange market efficiency in the three biggest economies in Asia including China, which has been excluded from research due to its exchange rate regime.

Liquidity Connectedness in the Foreign Exchange Market

We estimate the liquidity connectedness in the spot foreign exchange (FX) market based on an empirical network model. We find that the liquidity connectedness reflects the dynamic market uncertainties around the world. Supply- and demand-side factors are important drivers of liquidity connectedness, especially for the fear sentiment of investors and economic policy uncertainty. The relation between liquidity connectedness on the subsequent carry-trade return in the FX market is nonlinear and V-shaped. Overall, our research indicates that liquidity connectedness is a good measure of currency risk and can reflect the fragility of the FX market.