The Library

The information content of a limit order book : the case of an FX market

Tools

Kozhan, Roman and Salmon, Mark H. (Mark Howard), 1949-. (2012) The information content of a limit order book : the case of an FX market. Journal of Financial Markets , Vol.15 (No.1). pp. 1-28. ISSN 1386-4181

Preview

PDF
WRAP_Kozhan_290312-kozhansalmon2011.pdf - Accepted Version - Requires a PDF viewer such as GSview, Xpdf or Adobe Acrobat Reader
Download (555Kb)

Official URL: http://dx.doi.org/10.1016/j.finmar.2011.07.002

Abstract

In this paper we examine the question of whether knowledge of the information contained in a limit order book helps to provide economic value in a simple trading scheme. Given the greater information content of the order book, over simple price information, it might naturally be expected that the order book would dominate. Using Dollar Sterling tick data, we find that despite the in-sample statistical significance of variables describing the structure of the limit order book in explaining tick-by-tick returns, they do not consistently add significant economic value out-of-sample. We show this using a simple linear model to determine trading activity, as well as a model-free genetic algorithm based on price, order flow, and order book information. We also find that the profitability of all trading rules based on genetic algorithms dropped substantially in 2008 compared to 2003 data.

Item Type:	Journal Article
Subjects:	H Social Sciences > HG Finance
Divisions:	Faculty of Social Sciences > Warwick Business School > Financial Econometrics Research Centre Faculty of Social Sciences > Warwick Business School > Finance Group Faculty of Social Sciences > Warwick Business School
Library of Congress Subject Headings (LCSH):	Foreign exchange market -- Econometric models
Journal or Publication Title:	Journal of Financial Markets
Publisher:	Elsevier BV
ISSN:	1386-4181
Date:	2012
Volume:	Vol.15
Number:	No.1
Number of Pages:	28
Page Range:	pp. 1-28
Identification Number:	10.1016/j.finmar.2011.07.002
Status:	Peer Reviewed
Publication Status:	Published
Access rights to Published version:	Restricted or Subscription Access
References:	Alexander, S., 1961. Price movements in speculative markets: trends or random walks. Industrial Management Review 2, 7{26. Allen, F., Karjalainen, R., 1999. Using genetic algorithms to find technical trading rules. Journal of Financial Economics 51, 245{271. Anatolyev, S., Gerko, A., 2005. A trading approach to testing for predictability. Journal of Business & Economic Statistics 23, 455{462. Arifovic, J., 1996. The behavior of the exchange rate in the genetic algorithm and experimental economies. Journal of Political Economy 104, 510{541. Balvers, R., Wu, Y., 2010. Optimal transaction filters under transitory trading opportunities: Theory and empirical illustration. Journal of Financial Markets 13, 129{156. Bloomfield, R., O'Hara, M., Saar, G., 2005. The \make or take" decision in an electronic market: Evidence on the evolution of liquidity. Journal of Financial Economics 75, 165{199. Cao, C., Hansch, O., Wang, X., 2009. The information content of an open limit order book. The Journal of Futures Markets 29, 16{41. Chaboud, A., Chiquoine, B., Hjalmarsson, E., Vega, C., 2009. Rise of the machines: Algorithmic trading in the foreign exchange market. Working paper, Federal Reserve System . Chakravarty, S., Holden, C., 1995. An integrated model of market and limit orders. Journal of Financial Intermediation 4, 213{241. Chen, S., Duffy, J., Yeh, C., 1999. Genetic programming in the coordination game with a chaotic best-responce function, in: Proceedings of the 1996 Evolutionary Programming Conference, San Diego, CA. Chen, S., Yeh, C., 1997a. On the Coordination and Adaptability of the Large Economy: An Application of Genetic Programming to the Cobweb Model. In: Angeline, P. and Kinnear, K. (Eds.) Advances in Genetic Programming II, Cambridge MA, MIT Press. Chen, S., Yeh, C., 1997b. Toward a computable approach to the efficient market hypothesis: An application of genetic programming. Journal of Economic Dynamics and Control 21, 1043{1063. Chordia, T., Subrahmanyam, A., 2004. Order imbalance and individual stock returns: Theory and evidence. Journal of Financial Economics , 485{518. Cooper, M., 1999. Filter rules based on price and volume in individual security overreaction. Review of Financial Studies 12, 901{935. Danielsson, J., Luo, J., Payne, R., 2002. Exchange rate determination and inter-market order ow eects. Unpublished manuscript . Della Corte, P., Sarno, L., Tsiakas, I., 2009. An economic evaluation of empirical exchange rate models. Review of Financial Studies 22, 3491{ 3530. Dempster, M., Jones, C., 2001. A real time adaptive trading system using genetic programming. Quantitive Finance 1, 397{413. Dworman, G., Kimbrough, S., Laing, J., 1996. On automated discovery of models using genetic programming: Bargaining in a three-agent coalitions game. Journal of Management Information Systems 12, 97{125. Easley, D., O'Hara, M., 2010. Liquidity and valuation in an uncertain world. Journal of Financial Economics 97, 1{11. Evans, M., Lyons, R., 2005. Meese and rogo redux: Micro-based exchange rate forecasting. American Economic Review Papers and Proceedings 95, 405{414. Evans, M., Lyons, R., 2006. Understanding order ow. International Journal of Finance and Economics 11, 3{23. Fama, E., Blume, M., 1966. Filter rules and stock market tradings. Jounal of Business 39, 226{241. Foucault, T., 1999. Order ow composition and trading costs in a dynamic limit order market. Journal of Financial Markets 2, 99{134. Froot, K., Ramadorai, T., 2005. Currency returns, intrinsic value and institutional investor ows. Journal of Finance 60, 1535{1566. Giacomini, R., White, H., 2006. Tests of conditional predictive ability. Econometrica 74, 1545{1578. Glosten, L., 1994. Is the electronic open limit order book inevitable? Journal of Finance 49, 1127{1161. Granger, C., Machina, M., 2006. Forecasting and Decision Theory. In: Elliott, G. and Granger, C. and Timmermann, A. (Eds.) Handbook of Economic Forecasting, Elsevier. Granger, C., Pesaran, H., 2000. Economic and statistical measures of forecast accuracy. Journal of Forecasting 19, 537 { 560. Handa, P., Schwartz, R., 1996. Limit order trading. Journal of Finance 51, 1835{1861. Handa, P., Schwartz, R., 2003. Quote setting and price formation in an order driven market. Journal of Financial Markets 6, 461{489. Hansen, P., 2010. In-sample fit and out-of-sample fit: Their joint distribution and its implications for model selection. Working Paper, Stanford University . Harris, L., 1998. Optimal dynamic order submission strategies in some stylized trading problems. Financial Markets, Institutions & Instruments 7, 1{76. Harris, L., Hasbrouck, J., 1996. Market vs. limit orders: the SuperDOT evidence on order submission strategy. Journal of Financial and Quantitative Analysis 31, 213{231. Harris, L., Panchapagesan, V., 2005. The information content of the limit order book: evidence from the NYSE specialist trading decisions. Journal of Financial Markets 8, 25{67. Hellstrom, J., Simonsen, O., 2009. Does the open limit order book reveal information about short-run stock price movements? Unpublished manuscript . Hendershott, T., Jones, C., Menkveld, A., 2010. Does algorithmic trading improve liquidity? Journal of Finance 66, 1{33. Hillman, R., Salmon, M., 2007. Intrinsic stationarity: Investigating predictability in real-time forex transactions. Journal of Financial Forecasting 1, 3{43. Huang, R., Stoll, H., 1994. Market microstructure and stock return predictions. Review of Financial Studies 7, 179{213. Kaniel, R., Liu, H., 2006. What orders do informed traders use? Journal of Business 79, 1867{1913. Kavajecz, K., 1999. A specialist's quoted depth and the limit order book. Journal of Finance 54, 747{771. Knez, P., Ready, M., 1996. Estimating the profits from trading strategies. Review of Financial Studies 9, 1121{1163. Latza, T., Payne, R., 2010. Measuring the information content of limit order ows. Unpublished manuscript . Leitch, G., Tanner, E., 1991. Economic forecast evaluation: Profits versus the conventional error measures. American Economic Review 81, 580{590. Lo, A., 2004. The adaptive markets hypothesis. Journal of Portfolio Management 30, 14{29. Neely, C., Weller, P., 2001. Technical analysis and central bank intervantion. Journal of International Money and Finance 20, 949{970. Neely, C., Weller, P., 2003. Intraday technical trading in the foreign exchange market. Journal of International Money and Finance 22, 223{237. Neely, C., Weller, P., Dittmar, R., 1997. Is technical analysis in the foreign exchange market profitable? Journal of Financial and Quantitative Analysis 32, 405{426. Nix, A., Vose, M., 1992. Modeling genetic algorithms with markov chains. Annals of Mathematics and Artificial Intelligence 5, 79{88. Parlour, C., 1998. Price dynamics in limit order markets. Review of Financial Studies 11, 789{816. Pesaran, H., Skouras, S., 2002. Companion to Economic Forecasting. Blackwell Publishers. chapter Decision-based methods for forecast evaluation. pp. 241{267. Ranaldo, A., 2004. Order aggressiveness in limit order book markets. Journal of Financial Markets 7, 53{74. Rime, D., Sarno, L., Sojli, E., 2010. Exchange rate forecasting, order ow and macroeconomic information. Journal of International Economics 80, 72{88. Rock, K., 1996. The specialist's order book and price anomalies. Working paper, Harvard University . Rosu, I., 2010. Liquidity and information in order driven markets. SSRN Working Paper series . Sager, M., Taylor, M., 2008. Commercially available order ow data and exchange rate movements: Caveat emptor. Journal of Money, Credit and Banking 40, 583{625. Satchell, S., Timmermann, A., 1995. An assesment of the economic value of non-linear foreign exchange rate forecasts. Journal of Forecasting 14, 477{497. Seppi, D., 1997. Liquidity provision with limit orders and a strategic specialist. Review of Financial Studies 10, 103{150. Shadwick, W., Keating, C., 2002. A universal performance measure. Journal of Performance Measurement 6, 59{85. Vose, M., 1993. Modeling Simple Genetic Algorithms. In: Whitley, L. (Ed.) Foundations of Genetic Algorithms 2, Morgan Kaufman.
URI:	http://wrap.warwick.ac.uk/id/eprint/39608