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Trading activities and price discovery in foreign currency futures markets

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Abstract

This study investigates the relation between trading activities and the price discovery efficacy of the futures markets for EUR–USD and JPY–USD. According to data pertaining to weekly positions, collected from the Commitments of Traders reports distributed by the Commodity Futures Trading Commission, the information share of currency futures markets declines with hedgers’ positions but increases with speculators’ positions. In addition, both hedgers’ expected and unexpected positions have negative impacts on the contribution of the futures market; the futures market’s information share relates positively to speculators’ expected positions but is uncorrelated with speculators’ unexpected positions.

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Notes

  1. Previous studies focus on the relationship between traders' positions and future returns in the futures market (e.g., Wang 2001, 2003, 2004; Sanders et al. 2004; Röthig and Chiarella 2007; Chatrath et al. 2010) and the relationship between futures traders’ positions and spot returns (Klitgaard and Weir 2004; Tornell and Yuan 2012). In addition, Chang et al. (2000), Wang (2002a, b), and Bhargava and Malhotra (2007) investigate the relationship between positions by trader type and volatility in the futures market.

  2. Studying the price discovery process of futures and spot foreign exchange markets, Rosenberg and Traub (2009), Cabrera et al. (2009), and Chen and Gau (2010) find that the spot rates on the Electronic Broking Services (EBS) lead those in the futures markets in the Chicago Mercantile Exchange (CME).

  3. Speculators, hedgers, and small traders correspond to noncommercials, commercials, and non-reportable traders in COT reports, respectively.

  4. Focusing on the volatility, Bessembinder and Seguin (1993) find that both expected and unexpected components of open interest relate negatively to volatility. Considering the type of traders, Wang (2002a) concludes that expected net positions by type of trader do not relate to volatility. In contrast, the unexpected net positions of speculators and small traders have positive impacts on volatility, and the unexpected net positions of hedgers have negative impacts on it. Bhar and Malliaris (1998) find support, from five currencies futures, that price volatility is a determinant of the unexpected component of changes in trading volume.

  5. The CME futures trading occurs on two trading platforms: the GLOBEX electronic system and the open-outcry floor trading system. To be analogous with the electronic trading of EBS spot markets, we consider data from the GLOBEX trading system to find the relative contributions to price discovery of the currency spot and futures markets. Because GLOBEX futures rates, floor-traded futures rates, and spot rates in the foreign exchange markets are driven by the same underlying information, they should be closely related. Considering the price discovery among EBS spot, GLOBEX futures, and floor-traded futures rates simultaneously, we re-estimate a trivariate case of Hasbrouck information share, Lien-Shrestha modified information share, and Gonzalo-Granger common factor. The results show that the average information shares of the floor-traded futures market are lower than 10 % for JPY–USD and EUR–USD. Therefore, we exclude the price discovery efficacy of floor-traded futures, which should not distort the results. Due to data limitations, we cannot classify the different trader positions the GLOBEX and floor-traded futures. We thank a referee for suggesting the potential role of floor-traded futures in the price discovery process.

  6. The position or open interest of each class of traders has been announced by the CFTC every Tuesday since October 1992. The COT data have been used widely to investigate various issues, including the impact of trading activity by trader type on price movements and volatility in futures and spot markets, the forecasting ability of trading activities by trader type, risk premiums in the futures market, and even investor sentiment in the futures market. This interpretation regarding hedgers and speculators may be biased though. For example, Ederington and Lee (2002) find that noncommercials represent speculators well, but the commercials group likely includes some traders with no known positions in cash/forward markets, according to their data set gathered in the heating oil futures market.

  7. Following the naming device suggested by De Roon et al. (2000), Sanders et al. (2004) suggest that the percentage net long position held by speculators should be the “speculative pressure,” and that held by small traders is the “small trader pressure.”

  8. For practical uses, we normalize \(\gamma_{ \bot }\) to make the elements of \(\gamma_{ \bot }\) add up to 1.

  9. The average total positions of hedgers and speculators are 171,281.6 and 106,747.3. In contrast, the standard deviations of the total positions of hedgers and speculators are close. These results seem to indicate that the trading of speculators is more sensitive to market condition than is that of hedgers.

  10. The augmented Dickey-Fuller test statistic is obtained by including a linear time trend in the regression with the optimal lag length of 14, according to the Schwarz information criterion.

  11. As Chakravarty et al. (2004) note, the information share of the option market relates positively to the relative trading volume and bid–ask spread of options to spot markets. Mizrach and Neely (2008) also conclude that relative bid–ask spreads, number of trades, and realized volatility affect the daily relative information shares of the US. Treasury spot and futures markets. Wang and Yang (2013) find that price discovery is related to bid–ask spreads and relative volatility.

  12. We thank a referee for highlighting a potential multicollinearity problem and suggesting that we study the relationship between price discovery and trading activity (i.e., total positions, absolute net positions, expected and unexpected trading positions) by different types of traders separately.

  13. We thank a referee for suggesting the role of unexpected components of traders’ positions on price discovery.

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Acknowledgments

Yu-Lun Chen gratefully acknowledges financial support from the National Science Council (NSC 102-2410-H-033 -007 -MY2). Yin-Feng Gau gratefully acknowledges the financial support provided by the ATU Plan of the Ministry of Education in Taiwan.

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Authors and Affiliations

  1. Department of Finance, Chung Yuan Christian University, 200 Chung Pei Rd., Jhongli, 32023, Taoyuan, Taiwan

    Yu-Lun Chen

  2. Department of Finance, National Central University, 300 Jhongda Rd., Jhongli, 32001, Taoyuan, Taiwan

    Yin-Feng Gau & Wen-Ju Liao

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  1. Yu-Lun Chen
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  2. Yin-Feng Gau
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Correspondence to Yu-Lun Chen.

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Chen, YL., Gau, YF. & Liao, WJ. Trading activities and price discovery in foreign currency futures markets. Rev Quant Finan Acc 46, 793–818 (2016). https://doi.org/10.1007/s11156-014-0486-9

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