Essays in Honour of Charles Goodhart, Volume Two
Edited by Paul Mizen
Chapter 7: Trading activity, volatility and transactions costs in spot FX markets
7. Trading activity, volatility and transactions costs in spot FX markets Richard G. Payne* 1. INTRODUCTION In recent times, a fair amount of attention, from both academics and regulators, has been focussed on the links between the microstructures of securities markets and their ‘stability’. The question at the heart of this attention is whether microstructure factors can help explain the onset and persistence of market turbulence. After the event of a ‘market shock’, do the design of a trading system or the natural responses of liquidity suppliers and demanders in a market tend to exacerbate and/or prolong the shock’s eﬀects? Microstructure-level variables that are fundamental to investigations of this issue are liquidity and trading activity. Liquidity is an oft-discussed but rarely deﬁned concept. In what is to come, we will use the following deﬁnition: a liquid market is one in which an agent can immediately trade a reasonably large quantity with relatively small price impact. Trading activity can also be measured in several diﬀerent ways. More traditional measures of trading activity are simply counts of or aggregate volumes from recent transactions, regardless of whether trades were buyer or seller initiated. In what follows we employ one such measure – transaction frequency. However, a more relevant variable from a microstructure perspective, as emphasised in recent papers by Evans and Lyons (2002) and Chordia et al. (2001), is order ﬂow – the diﬀerence between the aggregate number/volume of buyer initiated and seller initiated trades in a particular interval. Order...
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