New Economics Papers
on Market Microstructure
Issue of 2010‒12‒23
two papers chosen by
Thanos Verousis

  1. A Transaction Data Study of the Forward Bias Puzzle By Francis Breedon; Dagfinn Rime; Paolo Vital
  2. Why does the Interest Rate Decline Over the Day? Evidence from the Liquidity Crisis By Angelo Baglioni; Andrea Monticini

  1. By: Francis Breedon (Queen Mary, University of London); Dagfinn Rime (Norges Bank (Central Bank of Norway)); Paolo Vital (University d'Annunzio)
    Abstract: Using ten years of FX transactions data we demonstrate that a large share of the FX forward discount bias can be accounted for by order flow. A simple microstructure-based decomposition suggests that order flow creates a timevarying risk premium that is correlated with the forward discount. The order flow related risk premium is particularly important in currency pairs traditionally associated with carry trade activity, as for these crosses it accounts for more than half of the forward bias (with the rest accounted for by systematic forecasting errors). We also find evidence that order flow is partly driven by carry trade activity, which is itself is driven by expectations of carry trade profits. However, carry trading increases currency-crash risk in that the carry-induced order flow generates negative skewness in FX returns.
    Keywords: Forward Discount Puzzle, FX Microstructure, Carry Trade, Survey Data
    JEL: F31 G14 G15
    Date: 2010–12–13
  2. By: Angelo Baglioni; Andrea Monticini (Catholic University, Milan, Italy)
    Abstract: We provide a simple model, able to explain why the overnight (ON) rate follows a downward intraday pattern, implicitly creating a positive intraday interest rate. While this normally reflects only some frictions, a liquidity crisis introduces a new component: the chance of an upward jump of the ON rate, which must be compensated by an intraday decline of the ON rate. By analyzing real time data for the e-MID interbank market, we show that the intraday rate has increased from a negligible level to a significant one after the start of the liquidity crisis in August 2007, and even more so since September 2008. The intraday rate is affected by the likelihood of a dry-up of the ON market, proxied by the 3M Euribor - Eonia swap spread. This evidence supports our model and it shows that a liquidity crisis impairs the ability of central banks to curb the market price of intraday liquidity, even by providing free daylight overdrafts. Such results have implications for the efficiency of the money market and of payment systems, as well as for the operational framework of central banks.
    Keywords: : interbank market, intraday interest rate, financial crisis, liquidity risk
    JEL: E4 E5 G21
    Date: 2010–11

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