Price Formation and Liquidity Provision in Short-Term Fixed Income Markets 1

Transcription

1 Price Formaion and Liquidiy Provision in Shor-Term Fixed Income Markes 1 Chris D Souza 2 Financial Markes Deparmen Bank of Canada Ingrid Lo Financial Markes Deparmen Bank of Canada Sephan Sapp Ivey School of Business Universiy of Wesern Onario April 2, 26 Absrac This paper examines price and liquidiy dynamics in shor-erm European and Canadian governmen securiies markes. The informaion conen of rades, relaive limi orders deph and s are examined. Order flow and relaive order book alances are comparaively informaive for European securiies lised on he dominan elecronic inerdealer rading plaform in Europe. In Canada, s are highly informaive. In general, informaion is usually fully incorporaed ino prices over a couple of hours. Lasly, we find ha prices do no adjus insananeously o heir fundamenal value in response o macro news innovaions. Raher, here is an induced effec hrough rades, orders and s. JEL Classificaion Numbers: G12, G14, G15 Keywords: Price discovery, liquidiy, governmen securiies markes, order flow, limi-orders 1 The views expressed in his paper are hose of he auhors, and no responsibiliy for hem should be aribued o he Bank of Canada. We wish o acknowledge he excellen research assisance of Jessica Liang. All remaining errors are our own. 2 Correspondence: Chris D Souza, dsou@bankofcanada.ca, 234 Wellingon Sree, Oawa, ON, Canada, K1A G9.

2 1. Inroducion Efficien and liquid governmen securiies markes are ofen viewed as imporan o a counry s economic well-being because hey perform a number of key roles. For example, given heir virually defaul-free naure, governmen securiies are used as benchmarks for he pricing and hedging of oher fixed-income securiies. In he shorerm ineres rae secor, liquid governmen markes allow financial marke paricipans o cos-effecively build posiions based on heir views of he expeced fuure pah of overnigh ineres raes. Moneary policy makers, concerned abou disorderly markes, can deermine if fuure ineres rae-seing decisions will surprise financial markes. Individual marke paricipans can examine he differences beween heir own forecas regarding he direcion and magniude of fuure rae changes and he overall marke s forecas. Only if shor-erm ineres rae markes are efficien, can accurae measures of marke expecaions be calculaed. 3 Governmen securiies markes, even hose ouside he U.S. Treasury marke, are usually hough o be highly liquid and efficien. This assumpion is esed wih new rade and quoe daa. In his paper, we examine how informaion is incorporaed ino European and Canadian governmen bond prices, how prices and liquidiy are joinly deermined, and he process by which news is incorporaed ino prices. I is imporan o accoun for he srucure and organizaion of a financial marke when invesigaing how prices and liquidiy evolve over ime. Albanesi and Rindi (2) find ha liquidiy and he process of price discovery improved once he posing of limi-orders became anonymous on he Mercao Telemaico dei Tioli de Sao (MTS) plaform---he dominan elecronic plaform for inerdealer rading of governmen securiies in Europe. Recenly, wih he inroducion of he euro in 1999, a liquidiy pac was adoped by 3 Johnson (23) describes how simple expecaions-based models can be uilized o exrac expecaions. Usually, securiies wih mauriies less wo years are employed in his exercise. 2

3 dealers and issuers of securiies lised on MTS. Marke makers of designaed securiies mus coninuously pos buy and sell limi-orders wihin a maximum bid-ask, for a minimum quoe amoun on boh sides of he marke, for a leas 5 hours each day. According o advocaes of he liquidiy pac, he accord should increases liquidiy in governmen securiies markes and hereby reduces he coss o governmens of funding heir deb. In Canada, a large proporion of governmen securiies rading ake place via inerdealer brokers (IDBs). While here are no quoing obligaions in Canada, dealers in he marke, usually represening financial insiuions, commi hemselves o rade coninuously in he marke by posing a bid price and an ask price for each governmen securiy. In eiher geographic region, dealers observe order flow, limi orders and s in he marke. In his paper, high-frequency rade and quoe daa from a number of shor-erm European and Canadian governmen securiies wih mauriy less han or equal o 2-years are analysed. Our paper invesigaes he relaionship beween price changes, order flow, relaive limi order deph and s. Green (24), Brand and Kavajecz (24) and Pasquariello and Vega (24) demonsrae ha order flow is informaive in fixed-income markes. In addiion o order flow, we also examine he role of liquidiy supply in price formaion process. Since relaive liquidiy supply provides an indicaion of how much dealers are willing o buy versus sell, i should convey informaion. Angel (1994) and Bloomfield, O Hara and Saar (23) illusrae how informed raders will use boh marke and limi orders sraegically. While Chordia, Sarkar and Subrahmanyam (25) also examine reurn and liquidiy dynamics across U.S. equiy and long-daed U.S. Treasury bond markes, very lile is known abou he price discovery process and liquidiy dynamics in governmen fixedincome markes for securiies wih mauriies less han wo years. This is especially rue of securiies issued ouside he U.S. Treasury marke. 3

4 The exisence of informed rading and liquid markes are relaed. Admai and Pfleiderer (1988) and Foser and Viswanahan (199) predic ha here will be a clusering of liquidiy and informed raders. Kim and Verrecchia (1994) argue ha, if informed raders possess an informaional advanage afer an even, liquidiy will remain low as long as hose informed raders mainain ha advanage. The supply of liquidiy in markes affecs he speed wih which informaion is incorporaed ino prices. In general, liquidiy should be viewed as endogenous. Moivaed by quesions associaed wih he relaionship beween price changes, order flow, relaive limi order deph and s, we uilize he framework of Hasbrouck (1991a, b) and Chordia, Roll and Subrahmanyam (2, 21). A reduced form vecor auoregression (VAR), in which each variable depends on he lagged values of he all oher variables, is esimaed. The persisen impac on prices from shocks o oher variables in he sysem is assumed o arise from asymmeric informaion. Our findings indicae ha here is a high degree of auocorrelaion in each variable which is consisen wih lagged adjusmen and/or invenory conrol effecs. Resuls sugges ha order flow and order book alances can have a permanen impac on prices. Unlike European securiies, s are paricularly informaive in he Canadian marke. Neverheless, in erms of he ime i akes markes o adjus, Canadian securiies are similar o hose of European securiies. We also examine he price and liquidiy dynamics in imes of macroeconomic news releases. These announcemens are public informaion which should affec prices immediaely before anyone can rade on hem. There may be a role for rades and orders in he price discovery process if paricipans differ abou how o inerpre macroeconomic news, or alernaively, if some raders are beer able o process public informaion. In his environmen, privae informaion will dissipae once i is firs refleced in rades and orders, and hen subsequenly in prices. Fleming and Remolona (1999) and Balduzzi, Elon, and Green (21) find ha U.S. Treasury markes reac o public macroeconomic informaion wih a sharp reducion in liquidiy combined wih rapid price changes as informaion is absorbed, and hen a 4

5 subsequen surge in rading aciviy as paricipans rade on heir differing views regarding he inerpreaion of he new informaion. Green (24) looks a he role of rading around macroeconomics news announcemens and finds ha informaion asymmery rises in he wake of an imporan macroeconomic news announcemen. Evans and Lyons (24) find ha news-induced rades las for days, and have persisen effecs on foreign exchange raes. In his paper, we examine he effecs of news innovaions and he reacion of order flow, order book alances and s. Like Evans and Lyons, we also find ha news generaes informed order flow bu uninformaive order book alance and s effecs. In he nex secion of he paper, Secion 2, we describe in more deail he insiuional srucure of he MTS elecronic rading plaform, he Canadian inerdealer brokered marke, and he daa employed in our sudy. In Secion 3, we discuss he empirical model esimaed. Our resuls and heir significance are explained in Secion 4. In Secion 5, we conclude. 2. Insiuional Srucure and Daa In Europe, he rading plaform in fixed-income securiies is he MTS, which is he dominan elecronic rading plaform. 4 Inerdealer rading accouns for more ha half of all rading volumes. 5 There are generally wo ypes of marke paricipans on MTS: primary dealers and dealers. Primary dealers mus fulfill a number of requiremens under a liquidiy pac wih issuers. These primary dealers mus coninuously pos buy and sell limi-orders wihin a maximum bid-ask, for a minimum quoe amoun, and for a given period of ime each day. In reurn for meeing hese obligaions, he primary dealers have access o primary aucions and enjoy privileged relaions wih he issuing 4 MTS was creaed in 1988 by he Ialian Treasury and he Bank of Ialy wih he objecive of increasing compeiion and efficiency in he marke for governmen deb. MTS became a privae company in EuroMTS was inroduced in The Bond Marke Associaion (TBMA, 25). 5

6 auhoriies. They also receive privae informaion abou he rading aciviy on MTS, marke and economic condiions, and policy informaion from issuers. European governmen bonds can be lised on a domesic MTS plaform (such as MTS France) and/or he EuroMTS elecronic rading sysem. Those fixed income securiies ha saisfy a number of lising requiremens, such as exceeding a required principal amoun ousanding and cerificaion ha a number of dealers ha will ac as markes marker in ha securiy, can be lised on EuroMTS. All governmen markeable securiies, in addiion o benchmarks, are lised on heir respecive domesic MTS plaform (subjec o a given ousanding principal amoun). Cheung, de Jong and Rindi (25) find ha rading coss are similar on boh plaforms. In our sudy, we examine rading and quoing informaion for Treasury bills from he domesic marke plaform since almos all rading of shor-daed securiies occurs on he domesic plaform. CanPx is a daa service ha consolidaes and disseminaes o ineresed subscribers anonymous rade and quoe daa submied by Canada s fixed-income inerdealer brokers (IDBs). Based on dealer saisics repored o he Invesmen Dealers Associaion (IDA), he Canadian inerdealer deb marke represened approximaely 46 per cen of he oal secondary Governmen of Canada bond marke rading volume during 22, of which IDB rading accouned for 86 per cen (up from 5 per cen in 1991 and 75 per cen in 1997). The CanPx daa se is relaively complee, in ha i receives informaion from all of he Canadian IDBs. Dealers leave firm quoes wih he brokers, along wih a minimum size ha hey are willing o rade. The bes quoes across all he paricipaing dealers are posed. Unlike MTS, dealer behaviour is no governed by rules ha limi bid/ask s. Daa This paper uses quoe and ransacion daa from he MTS rading plaform and CanPX. The MTS daase includes he updaes of he bes quoe, ransacion prices and signed quaniies raded along wih ime samps corresponding o he ransacions enering he marke. Informaion abou deph is available up o, and including, he hird bes ask and 6

7 bid prices. Our analysis below focuses on Treasury bills lised on he four larges MTS plaforms: MTS Ialy, MTS Germany, MTS France and MTS Belgium. We analyse shorerm governmen bill daa for securiies wih a mauriy from 6 monhs o 2 years. The MTS daa se spans he period from 1 April, 23 o 31 December 24. The MTS marke opens from 8:15 o 17:3 (Cenral European Time, CET) 6. We divide he rading day ino 3-minue inervals from 8: (CET) onwards. The bonds analysed in our sudy include: he 6-monh Ialian Treasury Cerificae (BOT), he 6-monh French Treasury Bill (FTB), he 6-monh German Treasury Cerificaes (GTC), he 1-year Belgian Treasury Cerificae, he 1-year Ialian Treasury Cerificaes (BOT), he 1-year French Treasury Bills (FTB), and he 2-year German Treasury Bond (Schäze). Daa from he Canadian bond marke comes from CanPx. We focus on he 2-year Canadian bond. 7 The CanPx daase spans from 1 s Ocober 23 o 31 s Ocober 24. We divide he rading day ino 3-minue inervals from 8: (Easern Dayligh Time, EDT) onwards. The following rade and quoe informaion relaing o a paricular securiy is available on he CanPX screen: he price and/or yield of he bes bid and offer; he oal amoun offered and bid a each of he bes inside quoes (across all of he IDB screens); he ime a which he bes bid and offer were las updaed; wheher a buyeriniiaed or seller-iniiaed rade is currenly being conduced; and, when a rade is compleed, he rade oucome and he name of he IDB where he rade ook place. One of he reasons we examine shor-erm insrumens is because lile is known abou he price and rade dynamics associaed wih hese securiies. The fixed-income marke microsrucure lieraure has usually focused on bonds wih more han 2 years o mauriy. We explore how privae informaion, order flow, and relaive liquidiy supply, order book alance (defined below), affec he shor-end of he yield curve. 6 There is a pre-rade session in he MTS marke from 7:45 o 8:15 (CET). During his ime, dealers can pos limi orders bu hey are no allowed o rade on hese orders. 7 We do no use he Canadian 6-monh and 1-year bill because he quoe and ransacion frequency is very low on he CanPx sysem. 7

8 Economic Announcemens All of he macroeconomic news announcemens we consider occur a, or afer, 8:3 a.m. EDT or CET. The announcemen daa, including he survey expecaion of he announcemens, are disseminaed by Bloomberg. We use real-ime daa on he expecaions and announced macro variables. The European sample includes EU-wide, Belgium, Ialy, France, Germany and US scheduled news. The Canadian sample includes Canada and US scheduled news. Boh he European and he Canadian news iems are lised in Table 6. For each announcemen we consruc he sandardized news, η i,, on half-hour inerval as, η i, N i, Ei, = (1) ˆ σ i where N, is he value announced of announcemen i, i expecaion of announcemen i, and E i, is he median of survey σˆ i is he sample sandard deviaion of se η on half-hour inervals on days wihou macroeconomic announcemen. i, = N i, E. We Variables and Descripive Saisics We consruc he following variables o examine price, informaion arrival and liquidiy dynamics: he 3-minue price change, alance, defined as where, and bes bid-ask, midquoe p, order flow,, order book. The change in he bes mid-quoe is = ( mid quoe mid quoe 1) *1 mid quoe is he average of he bes ask quoe and he bes bid quoe a he beginning of each period. Order book alance is defined as (deph a bes bid price *bes bid price deph a he bes ask price *bes ask price ) = 1 in which deph is measured in million. I capures he relaive supply of liquidiy on he wo sides of he marke. Order flow of he bond,, is he defined as he 8

9 aggregae volume of buyer-iniiaed orders minus ha seller-iniiaed order during he hour inerval. As shown in previous sudies (for example, Green (24), Brand and Kavajecz (24) and Pasquello and Vega (26) in fixed-income markes, order flow capures he arrival of informaion. The bes bid ask is defined as he difference beween he bes ask price and he bes bid price, ( bes ask price bes bid price) * 1 =. Table 1 presens he descripive saisics for he variables we model. European shorerm bills have lower serial correlaion in change in mid-quoe and higher serial correlaion in order book alance han Canadian 2-year bond. This may arise from he requiremen ha dealers in he MTS marke have o provide quoe for minimum quaniy for boh sides of marke for 5 hours per rading day. So dealers adjus heir quoe relaive quickly. From he correlaion marix, order flow is posiively correlaed wih changes in he mid-quoe over all securiies. Adjusmen of Time-Series Daa As we are using inra-day daa of 3-minue inerval, we deseasonalize he endogenous variables using he mehod proposed by Gallan, Rossi and Tauchen (1992). The firs sep is o regress each variable on a series of adjusmen variables as follows: x = d' λ + u (2) The adjusmen variables we use are half-hourly dummies, one for each of he hours beween 9: (GMT) and 5:3 (GMT) daily dummies, one for each from Monday o Thursday monhly dummies, one for each from February o December To remove he heeroscedasiciy in our variables, he residuals are used in he regression log( u 2 ) = d' θ + v (3) The adjused or deseasonalized variables are hen calculaed as follows 9

10 x ˆ uˆ = x δ x, (5) exp( d' θ / 2) adj + where x is he unadjused sample mean of he variables and δˆ x is he unadjused sample sandard deviaion. The adjused series have he same sample mean and variance as he unadjused series, bu he effec of seasonaliy on he mean and variance is removed. Table 2 shows he regressions coefficiens of Equaion (2). For European securiies, is highes a he beginning of he day. I drops as he rading day proceeds and hen rises slighly again before he closing of he marke. The resul is consisen wih he noion ha informaion asymmery is highes a he beginning of he day. Dealers wan o proec hemselves agains overnigh posiions before he marke closes so hey se a higher during hese imes. Spread is also in general higher on Friday. The findings conras wih ha of Canadian 2-year bond: is no saisically differen from he opening half-hour of he marke, excep for one half-hour inerval in he afernoon. 3. Mehodology: Economeric Specificaion Since marke orders, limi-orders and s are inerrelaed; he impac of an innovaion in one variable on prices canno be deermined by regressing prices on curren and lagged erms. In paricular, he execuion of a marke order will direcly affec he deph of limi orders on ha one side of he marke. Marke orders will also affec he fuure placemen and cancellaion of limi-orders. In reverse, marke orders may only be execued if a cerain amoun of deph is available in he marke. Complicaing hings furher, even afer allowing for causaliy in boh direcions beween order flow and order book alances, his relaionship will depend on he size of he bid-ask s in he marke a he ime of he marke order. In order o deermine he implied impac of a marke order, or a change in he relaive deph of he limi order book, i is necessary o capure he overall dynamic relaionship beween all variables. 1

11 In he paper, we use a vecor auoregression (VAR) model o capure he ineremporal associaions beween price, order flow, order book alance and. Hasbrouck (1991a, 1991b) proposed using wo saisics derived from he VAR specificaion o deermine he effecs of order flow on prices: impulse response funcions summarize he permanen impac of a variable on prices. Examining impulse response funcions, besides he esimaed coefficiens of a VAR, provide addiional insighs abou he behaviour of prices. Impulse response funcions represen he expeced fuure values of a sysem of equaions condiional on an iniial shock. By looking he impulse response funcion of price, informaion and liquidiy measures, we could examine he ineremporal dynamics of hese variables hrough ime in more deail. The second measure we use is variance decomposiions, which measure he relaive imporance of each variable in explaining he variabiliy in he endogenous variables. We examine he long-run response of an innovaion in a variable explain he error variance of mid-quoe change. The variance of he expeced value of all fuure prices changes can be hough of as he variance of he random walk componen implici in all asse prices. By examining he long-run response of price, informaion and liquidiy variables o innovaions in he sysem, variance decomposiion allows us o isolae he long-run impac hese variables from ransiory effec. These wo saisics are employed in our analysis o deermine he impac of innovaion in price, informaion and liquidiy measures on he marke qualiy of each governmen bond marke. We firs examine he dynamics of price, order flow and liquidiy measures on days wihou news announcemen by esimaing he following VAR sysem, where y is defined as = A1 y 1 + A2 y AP y P v, (1) y + y = [,,, p ]' and he A p s are (p p) coefficien marices of he endogenous variables, y. The disurbance, v is a column vecor wih mean zero, E( v ) = and serially uncorrelaed disurbances, and covariance marix E [ v v '] = Ω. The parameers A p and Ω are unknown and have o be esimaed before he necessary impulse response and variance 11

12 decomposiion saisics can be calculaed. Esimaes of hese parameers can be obained from leas squares. See Hamilon (1994) and Judge e al. (1982) for a discussion of hese mehods. We choose he order of Equaion (1) on he basis of he Akaike Informaion Crierion (AIC) and he Schwarz Informaion Crierion (SIC). We choose he minimum lag lengh from he wo crieria. We nex examine how he price, order flow and liquidiy measures respond o news announcemens. We esimae he following sysem: = A1 y 1 + A2 y AP y P + Bη v, y + where η is he (n 1) vecor of sandardized news variables from Equaion (1), where n denoes he number of macro economic news announcemen.. The (p n) coefficien marix of he news variables, is represened by B Thus he effec of announcemens on he dynamics of he endogenous variables is given by he B coefficiens. Our model enables us o examine on inraday basis how long he effecs of news announcemen persiss on price, order flow and liquidiy measures. 4. Empirical Resuls VAR Esimaion Resuls on Days wihou Macro News Announcemens The VAR specificaion described in he previous secion is esimaed for each of he eigh securiies in our sample. I consiss of four equaions ha model he ineracion beween he change in mid-quoe, s, order book alances, and order flow. The coefficien esimaes are repored in Table 3. The sysem of equaions is esimaed wih one or wo lags. For he Ialian 6-monh, he Ialian 12-monh, and he German 2-year bills only one lag was necessary. Table 4 shows he value of he objecive funcion a various lags for each VAR. Esimaion resuls are quie similar across securiies, and can be summarized as follows. There is evidence of posiive and significan order flow, order book alance, and 12

13 auocorrelaion. The coefficien of he firs lag for hese hree variables is in general posiively significan (a 1% significance level or lower) for all securiies. The resul associaed wih order flow suggess ha ha here exiss momenum in buying and selling. Auocorrelaion in s and order book alances can arise for a couple of reasons: (1) uncerainy of he securiy value persiss in he marke; or (2) a consrain exiss on he maximum imposed by MTS marke makers. The change in prices is significanly negaively auocorrelaed (a 1% significance level or lower) in he French 6-monh bill, he Ialian 6-monh bill, he German 6-monh bill and he Canadian 2-year bond. These resuls sugges he exisence of invenory conrol and lagged adjusmen effecs in hese markes. Turning o he cross-effecs of he endogenous variables in he price equaions, lag order flow has a significan impac on price dynamics in hree markes: he Ialian 6-monh bill, he French 1-year bill and he Canadian 2-year bond while lag order book alance has a posiive significan (a 1% level or lower) impac on he pricing of bonds expec in he German 6-monh bill, he Belgium 1-year bill and he Canada 2-year bond. These resuls sugges ha order flow and he relaive liquidiy supply se by dealers may convey informaion abou he pricing of securiies in he fixed income markes. One of he key quesions ha can be addressed wih a VAR is how useful are some variables in forecasing oher variables. Table 4 also shows he resuls of pair-wise Granger-causaliy ess beween each of he endogenous variables. One variable is said o Granger-cause anoher variable if he informaion in pas and presen helps o improve he forecass of he variable. We es he null hypohesis ha variable x1 does no Granger-cause variable x2 by esing wheher he lag coefficiens of x1 are joinly zero in he equaion wih x2 as dependen variable. For he French 6-monh bond, Wald es saisics indicae ha here is wo-way causaliy beween order book alances and price changes. For he Ialian 6-monh securiy, boh order flow and order book alances Granger-cause price change. There is no evidence of causaliy in he opposie direcion. In he German 6-monh marke, s, order book alance and order flow do no Granger cause price. Alhough here is wo-way 13

14 causaliy beween order flow and order book alances, and order book alances and s. The resuls of he Belgian 12-monh bill are similar o he German 6-monh bill: order flow, order book alance and variables do no Granger-cause price. For he Ialian 12-monh securiy, s and order book alances Granger-cause price changes in he VAR, hough here is no evidence he oher way around. For he 12-monh French marke, order flow and order book alance Granger-cause price. Again here is no evidence of causaliy in he oher direcion. For he German 2-year bond, order book alance Granger-cause price. Lasly, for he Canadian 2-year bond, here is evidence of wo-way causaliy beween price and s, and order flow is shown o Granger-causes prices. Overall, order book alances and order flow forecas price changes excep in he German 6-monh bill and he Belgian 1-year bill markes. Two-way causaliy exiss beween prices and all oher variables in he French 6-monh bill. Since here is in general a lack of uniformiy across securiies, we include all four variables in he VAR in all markes. We now examine he dynamics associaed wih innovaions in prices, order flow, order book alances and s. For each securiy marke, impulse response funcions are calculaed o race ou he effec of a one-ime shock o order flow, order book alance, and innovaions. Because he innovaions are correlaed, we orhogonalize he impulse using he inverse of he Cholesky decomposiion. We presen he resuls of he following ordering: order flow, order book alance, and price change. 8 The ordering was chosen for wo reasons. Firs, i is consisen wih he heoreical lieraure suggesing ha rades are informaive in he price formaion process. Therefore order flow is placed firs. Second, pair-wise Granger-causaliy ess provide evidence ha order book alances forecas price changes. Accordingly, order book alance is placed second, afer order flow, in he VAR ordering. 8 In general, he chosen VAR ordering can influence he resuls. Our resuls are very similar across orderings. 14

15 Figure 1 show he cumulaive effec on he change in prices from hree ypes of shocks: a one-sandard deviaion shock o order flow, a one-sandard deviaion shock o order book alances, and a one-sandard deviaion shock o s. Two sandards errors bounds of each impulse response funcion are also shown he graphs. The long-erm cumulaive implied price change ha occurs subsequen o an innovaion in each variable may be inerpreed as he informaional conen of ha variable. An order flow shock has a permanen and posiive impac on he prices of all European securiies and Canadian 2- year bond. This finding is consisen wih previous findings in he fixed-income microsrucure lieraure suggesing ha order flow is informaive and has a permanen impac in he price discovery process. Excep for he Belgium 1-year bill, order book alances have an iniial negaive impac on prices. The effec evenually dies ou wih prices revering back o he original level (or higher han heir original level in he case of French 1-year bill). The iniial drop in price is inconsisen wih our usual inuiion ha larger deph on he buy (bid) side of he marke should ac as a suppor level pushing prices upward. One explanaion for he iniial drop in price could be due o he feedback effec of order flow. A rise in deph on he buy side of he book reduces he marginal cos of selling a securiy. Dealers aemping o manage heir excess invenories are more inclined o immediaely execue marke sell orders raher han use limi orders. The execuion of sell may in urn convey negaive informaion o oher dealers abou he value of he securiy which may hen reduce prices. Only once dealers deermine ha he sell marke orders are no informaive does price rever o is iniial long-run level. The innovaion in s generally has no impac on prices amongs he European securiies excep in he Ialian 1-year bill marke. Spreads have a significanly posiive impac on he Ialian 1-year bill. For he res of he securiies, he impac of s is no saisically differen from zero, 5 hours afer he iniial impac. In conras, Canadian 2- year bond innovaions have a significan impac on price dynamics. An increase in s resuls in a permanen reducion in prices. From an informaional perspecive, large s in he marke may convince dealers ha informed raders may exis in he 15

16 marke. If liquidiy decreases as a resul, price may fall subsequenly. Spreads, much like order flow, seems o be informaive o dealers in he Canadian marke. Nex, we briefly discuss he ineracions beween order flow, order book alances and s. The impulse response funcion (no repored here) shows ha boh order book alances and s are posiively relaed own innovaions. Furher, he response of an order book alance innovaion on order flow is significanly negaive in he Ialian 6-monh bill, he Ialian 12-monh bill and he German 2-year bond. A negaive change in order book alances means ha he ask deph deepens a he bes ask price. The resul suggess ha dealers supply addiional liquidiy on he ask side upon observing more buy marke orders (wih posiive order flow) enering he marke. The response of order book alance o shock in order flow is quie differen in he German 6-monh marke. I is significanly posiive. This implies ha dealers deepens he bid deph, or wihdraw liquidiy from he ask deph, upon observing posiive order flow. For Belgium 1-year bill, he French 1-year bill and he Canadian 2-year bond, order book alance does no respond o innovaions in order flow. Turning o s, we find ha hey do no reac o innovaions in order flow excep for he Ialian 6-monh bill marke. The of Ialian 6-monh bill, he French 12-monh bill and he German 2-year bond reac posiively o innovaion in order book alance. Spreads do no reac o innovaions in order book alance in he res of he securiies. To furher deermine which variables are informaive in he price discovery process, we also examine he variance decomposiion of price changes. Table 5 shows he decomposiion of he 1-period ahead forecas variance of prices in erms of each componen variable in he sysem. We examine his paricular forecas so as o isolae any ransien effecs, focusing only on he long-run, or permanen, explanaory power of each variable in he VAR sysem. If a variable explains only shor-run ransien variaions in exchange rae changes, i will no perform well in he variance decomposiions. Since he variance decomposiion is based on he Cholesky idenificaion, i is affeced by he ordering of he variables. Table 5 displays he upper- and lower-bound esimaes of he 16

17 variance decomposiion for each endogenous variable from all possible ordering combinaions of order flow, order book alance, and s. The second column conains he forecas error of he variable a he given forecas horizon. The source of his forecas error is he variaion in he curren and fuure values of he innovaions o each endogenous variable in he VAR. The remaining columns give he percenage of he forecas variance due o each innovaion, wih each row adding up o 1. The conribuion of order flow, order book alances and s in explaining he error variance in price change differs across counries. Order flow s explanaory power on error variance of price change is close o 2 % for he Ialian 6-monh and 1-year bill, he Belgium one-year bill and he Canadian 2-year bond. Bu i has less han 1% of explanaory power in he German 6-monh bill and 2-year bond markes. This may be due o he fac ha, as described in Cheung, de Jong and Rindi (25), rading of German fixed-income securiies is concenraed in he fuures marke and rading on fuures is more liquid in he EUREX marke. As a resul, price discovery occurs in he fuures marke and he rading of he spo carries less informaion. Turning o order book alance, i has he highes explanaory power in he French 6- monh bill (above 7%) and he French 1-year bill (around 4%) markes. I also has lowes explanaory power on error variance of price in he Canadian marke. This could be due o he fac ha he Canadian marke is a voice-brokered sysem and here are no consrains imposed on s or he minimum quaniy supplied o he marke. As a resul, dealers can adjus boh s and relaive liquidiy supplies in imes of uncerainy. Thus relaive liquidiy supply order book alance has less weigh in explaining price dynamics. For s, he resuls sugges a very small role for s in he long-run pricediscovery process in European securiies. Since minimum s are resriced in Europe hrough he liquidiy pac, here informaion conen of on price is lower. The variaion in s may be exclusively relaed o manage invenories. Impulse response funcions of innovaion of on price confirm he finding as here is no permanen 17

18 impac of a shock on prices. For he Canadian 2-year bond, he resuls are significanly differen. Spreads explain beween 22 and 23% of he long-erm variabiliy in prices. The resul suggess ha s in he Canadian bond marke are relaed o innovaions in fundamenal informaion. Impulse Response Funcions and News Innovaions In his secion, we characerize he behaviour of prices, order flows, order book alances and s subsequen o news releases. Specifically, we focus on analysis on how news affecs each of he variables in our VAR sysem beyond he announcemen ime. We aemp o deermine if news induces changes in order flow, order book alances, s, which hen affec prices laer hrough ime. While macroeconomic news announcemens will affecs prices direcly before anyone can rade on i, afer he announcemen is made, privae informaion may sill exis if paricipans differ on how o inerpre he macroeconomic news. Green (24) finds ha informaion asymmery rises in he wake of an imporan macroeconomic news announcemen. Over ime, privae informaion in he marke will dissipae once i is refleced in rades and order flow, and hen subsequenly in prices. Evans and Lyons (24) find ha here is evidence of an indirec channel beween news and prices hrough order flow in he FX marke. Table 6 repors he esimaed coefficiens, B, and heir significance, of news innovaion on each endogenous variable in he VAR in Equaion (2). These coefficiens deermine he average effec of news shocks on innovaions in he VAR. U.S. Non-farm Produciviy and he German IFO index survey of business climae have he larges significan impac on European securiy prices. U.S. Non-farm Produciviy has a significanly posiive impac on he price change of all European securiies excep he Ialian 6-monh bill and he German 6-monh bill. A posiive one sandard deviaion shock o Non-farm Produciviy leads o price change of more han 3 cens on Ialian 1- year bill and German 2-year bond. The German IFO index survey of business climae has a significanly negaive impac on he price change of all European securiies excep he Ialian 6-monh bill and he German 6-monh bill. A posiive shock of one sandard 18

19 deviaion o German IFO Index Survey of Business Climae leads o more han 2 cens decline on Ialian 1-year bill and German 2-year bond. Order book alances and s are affeced by a wide range of news innovaions. The French Consumer Confidence Indicaor, French Non-farm Payrolls, French PPI, he CPI and PPI of Ialy, Germany and US are among he mos imporan macroeconomic news variables affecing order book alances and s. As in he case of price changes, here is a significan cross-counry news innovaions impac on each of he oher variables in he VAR sysem. For example, an innovaion in he French Consumer Confidence Indicaor has a significanly negaive impac on he order book alances of he Ialian 1-year bond. The magniude of he impac is second only o he French 6- monh bill. Similarly, he innovaions in French Non farm Payrolls and PPI have he greaes impac on he order book alances of he Belgium 1-year bill and he of he German 2-year bond. In erms of he Canadian 2-year secor, ou of all he macroeconomic news evens ha were hough o have an impac on governmen fixed income markes, only a few had a saisically significan conemporaneous impac on prices. The price dynamics of he Canadian 2-year bond is no significanly affeced by any news innovaions. Canadian indusrial producion prices (PPI) and U.S. Non-farm Employmen Produciviy are shown o have posiive and saisically significan impac on order flow. U.S. Reail Sales and Housing Sars have a saisically significan impac on Canadian s. To deermine if here is a persisen impac of news on he endogenous variables in our sysem, we presen he resuls of several macroeconomic news innovaions ha have been shown o have a conemporaneous effec. U.S. Non-farm Produciviy French PPI, German IFO Index of Business Climae, and Ialian CPI have a saisically significan impac on a leas one variable in one endogenous variable across each European securiy. Boh U.S. Non-farm Produciviy and Canadian Indusrial Producion Prices boh have an impac on he price of he Canadian 2-year on-he-run bond. Figure 2 summarize he 19

20 dynamics of prices, order flow, order book alances and s following he arrival of each news evens hrough an examinaion of impulse response funcions. In a number of cases here is a delayed order flow, order book alance and response afer he news even. Prices do no converge o long-run value insananeously. In he firs figure he reacion o a one-sandard deviaion innovaion in French PPI on he accumulaed prices change, accumulaed order flow, order book alances, and s in each securiy marke is ploed. Noe ha price changes and order flow are illusraed in cumulaive amouns since hey are flow variables in he VAR sysem. Judging from he op-righ-hand-side plo, cumulaive order flow is increasing even afer 6 inervals, or 3 hours. In he firs wo inervals prices are also adjusing, parly direcly hrough a lagged adjusmen in own prices, bu also indirecly hough order flow. Spreads and alances (lower plos in Figure 2) adjus over a longer period of ime. The German 2- year bond usually has he larges emporary adjusmen in s and order book alances o a news innovaion. There is a similar reacion o news innovaions in he Canadian 2-year bond marke. Prices do no adjus insananeously o long-run value in response o innovaion in news, bu adjus over he nex one o wo hours. There is also evidence ha here is induced order flow which indirecly affecs prices. Much like he reacion of European securiies o news, boh order book alances and s adjus over a period of 3-hours. Since prices have adjused in inerim, hese dynamics are probably associaed wih invenory conrol affecs. 5. Summary and Conclusion Liquid and efficien governmen securiies markes are imporan o a counry s overall economic well-being. They are necessary o ensure ha savings and invesmen decisions are made opimally. In his paper, we examined he dynamics of price, order flow, order book alance and on shor-erm European and Canadian governmen securiies. 2

21 We also analysed he relaionship beween price and liquidiy dynamics on days wih macroeconomic news announcemens. On non-announcemen days, consisen wih he res of he lieraure, order flow has a permanen and posiive impac on price. A shock in order book alance leads o an iniial drop in price bu hen price revers back o he long-run level. A shock o s does no have a significan long-run impac excep in he Canadian markes. One imporan feaure of governmen deb markes is he exen o which hey are driven by public news, and, in paricular, macroeconomic news. The informaion in scheduled macroeconomic news releases is scruinized by he marke, whose paricipans seek o deermine he fuure cos of capial. One way in which markes process informaion is by observing order flow, order book alances and s. We found ha liquidiy measures have delayed response o news innovaions. I may akes some ime before news is fully refleced in prices. Wihou a larger sample of securiies, and addiional cross-secional informaion abou each securiies marke, we canno make addiional commens abou he conribuion of marke srucures o price discovery and liquidiy dynamics, or more imporanly wheher a liquidiy pac is needed in he Canadian governmen securiies marke. Overall, our resuls sugges ha, while here are some differences in dynamics, Canadian and European shor-erm fixed-income marke are relaively liquid; hey reflec fundamenal informaion in a imely fashion; and hey reac o news in a manner consisen wih evidence from oher financial markes. In fuure research we will build on resuls of his paper and explore how prices and relaive liquidiy supplies are joinly deermined across on-he-run and off-he-run securiies markes. Since dealers in fixed-income marke usually manage a porfolio of securiies wihin a given mauriy secor, if securiies are similar, a dealer can have a long posiion in one securiy and an offseing shor posiion in anoher and bear lile invenory risk. Primary dealers of boh on- and off-he-run securiies can manage risk in heir porfolio by adjusing prices and liquidiy supplies of he wo securiies joinly. We 21

22 will also seek o deermine if privae informaion learned abou one securiy is used in he pricing decisions of oher similar securiies. Invenory conrol effecs may link on- and off-he-run securiies. 22

23 References Admai, A., Pfleiderer, P A heory of inraday paerns: volume and price. Review of Financial Sudies 1, 3-4. Albanesi, S., Rindi, B., 2. The qualiy of he Ialian Treasury bond marke, asymmeric informaion and ransacion coss. Annales d Economie e de Saisique 6, Angel, J., Limi versus marke orders. Georgeown Universiy Working. Balduzzi, P., Elon, E., Green, C., 21. Economic news and bond prices: evidence from he U.S. Treasury marke. Journal of Financial and Quaniaive Analysis 36, Bloomfield, R., O Hara, M. and Saar, G., 23, The make or ake decision in an elecronic marke: Evidence on he evoluion of liquidiy. Journal of Financial Economics, forhcoming Brand, M., Kavajecz, K. 24. Price discovery in he U.S. Treasury marke: The impac of order flow and liquidiy on he yield curve. Journal of Finance, 59, Cheung, Y., de Jong, F., Rindi, B., 25. Trading European sovereign bonds. The microsrucure of he MTS rading plaform. ECB working paper. Chordia, T., Roll, R., Subrahmanyam, A., 2. Commonaliy in liquidiy. Journal of Financial Economics 56. Chordia, T., Roll, R., Subrahmanyam, A., 21. Trading aciviy and expeced sock reurns. Journal of Financial Economics 59, Chordia, T., Sarkar, A., Subrahmanyam, A., 24. An empirical analysis of sock and bond marke liquidiy. Review of Financial Sudies, forhcoming. Evans, M., Lyons, R., 24. Do currency markes absorb news quickly? U.C. Berkeley Unpublished working paper. Fleming, M., Remolona, E., Price formaion and liquidy in he U.S. Treasury marke: The response o public informaion. Journal of Finance 54, Foser, F., Viswanahan, S., 199. A heory of inerday variaions in volumes, variances and rading coss in securiies markes. Review of Financial Sudies 4, Gallan, A. Rossi, P., Tauchen, G., Sock prices and volume. Review of Financial Sudies

24 Greene, W., Economeric Analysis, 5h Ediion. Upper Saddle River, NJ: Prenice- Hall. Hamilon, J., Time series analysis. Princeon Universiy Press, Princeon, New Jersey. Hasbrouck, J., Measuring he informaional conen of sock rades. Journal of Finance 46, Hasbrouck, J., 1991, The summary informaiveness of sock rades: An economeric analysis, Review of Financial Sudies Johnson, G., 23. Measuring ineres rae expecaions in Canada. Bank of Canada working paper Judge, G., Hill, R., Griffihs, W., Lkepohl, H., Lee, T., Inroducion o he heory and pracice of economerics, Wiley, New York. Kim, O., Verrecchia, R Marke liquidiy and volume around earnings announcemens. Journal of Accouning and Economics Pasquariello, P., Vega, C., 24. Informed and sraegic order flow in he bond markes. Unpublished working paper. The Bond Marke Associaion (TBMA) and he European Primary Dealers Associaion, 25. European bond pricing sources and services: Implicaions for price ransparency in he European bond marke. 24

25 Table 1: Summary Saisics Tables and Figures Summary saisics for French 6-monh bill, Ialian 6-monh bill, German 6-monh bill, Belgium 1-year bill, French 1-year bill, Ialy 1-year bill, German 2-year bond and Canadian 2-year bond. The mid-quoe change, p, is he 3-minue change in mid-quoe imes 1. Order book alance is defined as (deph a bes bid price *bes bid price deph a he bes ask price *bes ask price ) = 1 in which deph is measured in million. Order flow of he bond,, is he defined as he aggregae volume of buyer-iniiaed orders minus ha seller-iniiaed order during he hour inerval. The bes bid ask is defined as he difference beween he bes ask price and he bes bid price. mean sd ρ 1 ρ 2 ρ 3 p France 6-monh bill p Ialy 6-monh bill p Germany 6monh bill p Belgium 1-year bill p Ialy 1-year bill p

26 France 1-year bill p Germany 2-year bond p Canada 2-year bond p

27 Table 2: Adjused Regressions of Price Change, Order Flow, Order Book Imbalance and Spreads The mid-quoe change, p, is he 3-minue change in mid-quoe imes 1. Order book alance is defined as (deph a bes bid price *bes bid price deph a he bes ask price *bes ask price ) = 1 in which deph is measured in million. Order flow of he bond,, is he defined as he aggregae volume of buyer-iniiaed orders minus ha seller-iniiaed order during he hour inerval. The bes bid ask is defined as he difference beween he bes ask price and he bes bid price. We deseasonalize p,, and using he mehod proposed by Gallan, Rossi and Tauchen (1992). We regress each variable on a series of adjusmen variables as follows: x = d' λ + u (2) The adjusmen variables we use are half-hourly dummies, one for each of he hours beween 9: (GMT) and 5:3 (GMT) daily dummies, one for each from Monday o Thursday monhly dummies, one for each from February o December Esimaion is done via ordinary leas squares. Esimaes wih * are significan a 1% significance level and esimaes wih ** are significan a 5% significance level. 27

28 Panel A: French 6-monh bill p inercep **.79* 9:- 9: ** 9:3-1: ** 1:-1: ** 1:3-11: ** 11:-11: ** 11:3-12: ** 12:-12: * -.33** 12:3-13: ** -.31** 13:-13: ** 13:3-14: ** 14:-14: ** 14:3-1 5: ** 15:-15: * -.3** 15:3-16: * -.25** 16:-16: ** 16:3-17: * -.22** 17::17: ** Monday -.11** ** Tuesday ** Wednesday -.1* ** -.8** Thursday -.11** ** Feb **.1** Mar **.1** Apr **.31** May.1.7* ** Jun **.29** Jul **.36** Aug **.16** Sep **.16** Oc **.19** Nov **.4** Dec **.32** Panel B: Ialian 6-monh bill p inercep * 9:- 9: ** 9:3-1: ** 1:-1: ** 1:3-11: ** 11:-11: * -.46** 11:3-12: ** 12:-12: ** 12:3-13: ** 13:-13: ** 13:3-14: ** 14:-14: ** 14:3-15: ** 15:-15: ** 15:3-16: ** 16:-16: ** 16:3-17: ** 17::17:3 1.48** * Monday -.52** ** Tuesday -.42* ** Wednesday -.45* ** Thursday -.52** ** Feb Mar *.3 Apr ** May.79* * Jun * 1.45*.93** Jul ** Aug ** Sep * Oc Nov * -.3 Dec *.11

29 Panel C: German 6-monh bill p inercep 2.98** 1.3* -6.93** 1.11** 9:- 9:3-3.28** ** 9:3-1:3-3.1** 1.83** ** 1:-1:3-3.15** ** 1:3-11: -3.34** ** 11:-11:3-3.22** ** 11:3-12: -3.15** ** 12:-12:3-3.17** ** -.26** 12:3-13: -3.2** ** 13:-13:3-3.2** ** 13:3-14: -3.25** ** 14:-14:3-3.29** ** 14:3-15: -3.27** ** 15:-15:3-3.16** ** 15:3-16: -3.2** ** 16:-16:3-3.8** ** 16:3-17: -3.3** ** 17::17:3-3.27** ** Monday ** ** Tuesday ** -1.94** -.7** Wednesday * -2.16** -.3** Thursday * -1.4** -.2* Feb ** -.13** Mar * 5.87** -.14** Apr ** -.1 May ** -.1** Jun ** -.16** Jul ** -.11** Aug ** -.13** Sep 1.61* ** -.13** Oc ** 5.3** -.19** Nov * 8.76** -.14** Dec **.5** Panel D: Belgium 1-year bond p inercep ** 9:- 9: ** 9:3-1:3.79** ** 1:-1:3.76** ** 1:3-11: ** 11:-11: ** -.57** 11:3-12:.6* * -.57** 12:-12:3.68** ** 12:3-13: ** 13:-13:3.62* ** -.56** 13:3-14:.59* ** -.57** 14:-14: * -.37** 14:3-15: ** 15:-15:3 1.5** ** 15:3-16:.7** ** 16:-16: * -.38** 16:3-17:.66** ** -.26** 17::17:3.69** **.6 Monday -.35* * Tuesday ** Wednesday ** Thursday * -.7** Feb ** Mar ** Apr **.31** May * * Jun ** Jul ** Aug Sep Oc *.12** Nov ** Dec **