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Monetary History, Exchange Rates and Financial Markets

Essays in Honour of Charles Goodhart, Volume Two

Edited by Paul Mizen

Monetary History, Exchange Rates and Financial Markets is an impressive collection of original papers in honour of Charles Goodhart’s outstanding contribution to monetary economics and policy. Charles Goodhart has written extensively on many of these topics and has become synonymous with his field; the chapters within this book offer a summary of current thinking on his own research subjects and include perspectives on controversies surrounding them.
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Chapter 7: Trading activity, volatility and transactions costs in spot FX markets

Richard G. Payne


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 flow is important as it indicates the balance of liquidity demand,...

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