Do Futures Lead Price Discovery in Electronic Foreign Exchange Markets?

Transcription

1 Do Fuures Lead Price Discovery in Elecronic Foreign Exchange Markes? Juan Cabrera Tao Wang Jian Yang Juan Cabrera is a Ph.D. candidae in he Deparmen of Economics a he Graduae School of he Ciy Universiy of New York, New York; Tao Wang is an Assisan Professor of Economics in he Deparmen of Economics a Queens College and he Graduae School of he Ciy Universiy of New York, New York; Jian Yang is an Associae Professor of Finance in he Business School a Universiy of Colorado Denver, Denver. The auhors hank he edior and paricularly an anonymous referee for very exensive commens, which have subsanially improved he paper. The auhors also hank Joel Hasbrouck for making available he SAS program for he price discovery analysis. *Corresponding auhor. The Business School, PO Box , Universiy of Colorado Denver, Denver, CO [email protected]. Tel: (303) ; Fax: (303) Journal of Fuures Markes (Final Revision)

2 Do Fuures Lead Price Discovery in Elecronic Foreign Exchange Markes? ABSTRACT Using inra-day daa, his paper invesigaes he conribuion o he price discovery of Euro and Japanese Yen exchange raes in hree foreign exchange markes based on elecronic rading sysems: he CME GLOBEX regular fuures, E-mini fuures, and he EBS inerdealer spo marke. Conrary o evidence in equiy markes and more recen evidence in foreign exchange markes, he spo marke is found o consisenly lead he price discovery process for boh currencies during he sample period. Furhermore, E-mini fuures do no conribue more o he price discovery han he elecronically raded regular fuures. JEL Classificaions: C32, F31, G13, G14 Keywords: price discovery, elecronic rading, foreign exchange markes, spo and fuures, E- mini

3 Do Fuures Lead Price Discovery in Elecronic Foreign Exchange Markes? INTRODUCTION Price discovery is he process hrough which closely relaed markes aemp o reach he equilibrium price. While price discovery may be considered o be immediae in fricionless Walrasian models of rading behavior which ypically assume perfec compeiion and free enry, such assumpion is deemed far from realisic in he marke microsrucure lieraure. In fac, i has been one of he mos criical quesions in marke microsrucure o invesigae how prices are acually deermined inside he black box of a securiy marke and he process by which prices come o impound new informaion. In paricular, he roles of spo and fuures (and oher derivaive financial insrumens) in he price discovery process have received much aenion. In he currency marke, he size of he currency fuures marke is relaively small compared wih he over-he-couner spo marke. According o he 2007 BIS Triennial survey, average daily volume in exchange-raded currency producs oaled 72 billion compared wih 2,319 billion in over-he-couner producs. Thus, In FX, however, he fuures marke is much smaller han he spo marke; i is unlikely ha a significan share of price deerminaion occurs here. (Lyons, 2001) Recen evidence, however, suggess ha he currency fuures marke migh play a big role in price discovery compared wih he spo marke. Using inerdealer direc spo ransacions marke daa from he Reuers Dealing sysem and he fuures daa from he regular floors rading on he CME for hree monhs in 1996, Rosenberg and Traub (2007) found he currency fuures marke can have informaion shares averaging beween 80 and 90 percen based on he mehodology in Hasbrouck (1995) and Gonzalo and Granger (1995). The currencies hey examined are he Deusche Mark, he Briish Pound, he Japanese Yen and he Swiss Franc. 1 On he oher hand, Tse, Xiang, and Fung (2006), using boh he 1

4 GLOBEX elecronic and floor-rading fuures daa a he CME, and he CMC foreign exchange reail-rading daa for hree monhs in 2004, repored ha he GLOBEX elecronic fuures provide he mos price discovery in he Euro, and he on-line reail-rading spo marke provides he mos price discovery in he Japanese Yen. Therefore, he resuls from Tse, Xiang, and Fung (2006) confirm ha of Rosenberg and Traub (2007) in he case of he Euro bu no for he Yen. This unseled issue is paricularly imporan, given he recen dramaic changes in he srucure of he foreign exchange marke as a whole (Rime 2003). This paper provides a comprehensive analysis of he dynamic price discovery process in he elecronic foreign exchange markes for wo currency pairs, he Euro/US$ and he Yen/US$. We differ from he exising lieraure in he following aspecs. Firsly, differen from previous sudies, his sudy uses he inerdealer spo marke daa from he elecronic brokering services (EBS) from April o July of In he spo marke, mos of he foreign exchange rading is concenraed in he inerdealer marke. This EBS daase has several imporan advanages. Specifically, he EBS daase consiss of ransacable quoes, as opposed o ransacion prices from Reuers D sysem used in previous sudies (e.g., Evans, 2002; Rosenberg and Traub, 2007). Furhermore, EBS has become he major rading plaform for he wo mos raded currency pairs, he Yen and he Euro, making he resuls based on his daase a rue represenaion of he behavior of global inerdealer foreign exchange markes. 2 If he comparison beween spo and fuures needs o be made, he EBS daa should provide he bes represenaion for he spo marke wih regard o he Euro and he Yen. Secondly, his paper examines he price discovery role of elecronic-raded foreign exchange spo and fuures markes. The allowance for he confounding effec of elecronic rading is imporan as elecronic rading has become a major facor in affecing he relaive rae of price discovery across differen markes. There is subsanial empirical evidence 2

5 showing ha he use of elecronic rading plaforms faciliae price discovery more efficienly han floor rading in equiy markes (e.g. Hasbrouck, 2003; Kurov and Lasser, 2004). Recenly, Aes and Wang (2006) and Tse, Xiang, and Fung (2006) have demonsraed he informaional dominance of he elecronically raded regular fuures markes over he floor raded regular fuures. Neverheless, no sudy has compared elecronically raded foreign exchange spo and fuures markes, wih he noiceable excepion of Tse, Xiang, and Fung (2006). Finally, his is he firs aemp o invesigae he role of E-mini fuures in price discovery for he Euro/US$ and he Yen/US$. The CME inroduced E-mini Euro and Yen fuures in Ocober The evidence of he dominan role of E-mini fuures in price discovery has been recorded from equiy markes (Hasbrouck, 2003; Kurov and Lasser, 2004; Aes and Wang, 2005). However, o he bes of our knowledge, no oher sudy has explored he price discovery role of E-mini fuures on foreign exchange markes. The res of he paper is organized as follows. Secion 2 presens he daa. Secion 3 describes he esimaion procedure and presens he resuls. A brief summary concludes he paper in Secion 4. DATA DESCRIPTION The daase consiss of inraday ick by ick observaions (laer convered o 5-second inervals in he analysis) covering a four-monh period from April 4h, 2005 unil July 29h, Prices are log-ransformed and muliplied by a consan number ( p = log( p ) 10, 000 ). Daa were obained for hree major financial insrumens (regular fuures, E-mini fuures and he inerdealer spo marke) in wo currency markes (Euro/$ and yen/$). Boh E-mini fuures and he spo marke are elecronically raded while regular fuures have boh floor rading and elecronic rading a he same ime from 7:20 a.m. o 2:00 3

6 p.m., bu only elecronic rading in oher imes. In his sudy, however, only daa from elecronic rading are used. 4 Fuures Marke Daa The regular and E-mini fuures daa are he ime and sale daa from he Chicago Mercanile Exchange (CME). These fuures are he mos acively raded FX fuures in he CME. Table I provides he summary saisics for he fuures conracs used in his paper. Specifically, for he regular fuures conracs, hey are no only raded a he CME Globex elecronic marke bu also are raded side-by side wih he floor rading using he open oucry sysem during he regular hours. CME E-mini Japanese Yen fuures and E-mini Euro fuures began rading in 1999 exclusively on CME Globex. E-mini fuures conracs are sized a onehalf of he regular fuures conracs o make E-mini rading affordable o raders wih small margin accouns. While CME offers a forum for rading he Yen and he Euro in is FX fuures markes on boh is Globex elecronic rading plaform as well as on he rading floor, he rading hours differ across hese wo rading venues (see Table I). This sudy will only include inraday daa for he period of he day when all markes are open (7:20 am o 2:00 pm). These daily samples will make i possible o analyze he price dynamics during informaioninensive periods, as he daa will also (a leas parially) capure any informaion generaed in he floor rading during his period. For he fuures conracs, he nearby conrac is he mos acive conrac. Therefore, only he las hree full monhs of he life of nearby conracs are used, and hey are rolled over o he nex nearby conrac he las day of he monh prior o he expiraion monh. Hence, he sample period for he regular fuures conracs is consruced using ransacion prices from wo monhs (April and May) of he June 2005 conrac and wo monhs (June and July) of he Sepember 2005 conrac. 4

7 The fuures volume saisics in Table I show ha he mos frequenly raded is he Euro/US$ regular fuures conrac. On he oher hand, he Yen/US$ E-mini fuures conrac is far less raded han any of he oher insrumens. Day rading on Globex seems o be he mos acive of all. Nigh and overnigh rading accouns for roughly 25% of he daily volume in all markes. Furhermore, floor rading accouns for a very small percenage of he oal daily volume in hese derivaive markes. The informaion clearly suggess he araciveness of he sample daa which covers day rading in he elecronic markes (GLOBEX). Spo Marke Daa The spo foreign exchange marke is much less cenralized han he FX fuures markes. This marke is bes described as a decenralized muliple-dealer marke. There is no physical locaion or exchange where dealers mee oher raders, nor here is a screen ha consolidaes all execuable quoes in he marke. In his way, he spo FX marke is very differen from mos fuures markes. Dominaed by inerbank rading, spo currency ransacions occur in he over-he-couner (OTC) markes. Cash currency rading akes place in a number of inerconneced markes. On he oher hand, privae vendors offer elecronic rading plaforms and marke daa available for a fee. These reail markes are very accessible o small raders; however, hese reail markes are differen from he iner-dealer marke where large raders accoun for mos of he daily rading volumes in he currency markes. The spo currency marke paricipans are banks, commercial companies, cenral banks, invesmens companies, and reail FX brokers. There are 3 main feaures ha disinguish spo FX markes from oher markes: a very high rading volume, inerdealer rading accouns for mos of he volume, and ransparency is low. The spo marke daa for his sudy were colleced from one of he wo leading elecronic brokers of inerdealer spo foreign exchange marke, EBS. Alhough reail elecronic rading in he FX spo markes has been exploding, mos of he rading is 5

8 concenraed in he inerbank marke. Currenly, wo elecronic brokering sysems are used globally for inerbank spo rading, one offered by Elecronic Broker Sysem (EBS) and one offered by Reuers (Dealing 3000). The Euro/US$ and he Yen/US$ are raded primarily on EBS. Therefore, our daa were colleced from he leading elecronic brokering sysem in he Euro/US$ and he Yen/US$ inerbank markes, which comprise mos global ransacions in hese wo FX markes. This daa provider offers a screen-based anonymous dealing service, operaing during global rading hours, which suppors rading in all major currencies. Each day 2,000 raders on more han 700 floors globally use his rading plaform o rade an average of USD145 billion a day in spo foreign exchange ransacions. The daa obained for he spo raes are he bid/ask midpoin. As menioned in he inroducion, he EBS has become he major rading plaform for he wo mos raded currency pairs, he Yen and he Euro. Table II repors he summary saisics of all currency markes for boh exchange raes. During he 4-monh period covered in he sample, rading aciviy in erms of price quoe is significanly higher in he regular fuures and spo markes. For he Euro marke, he number of ransacions is higher in regular fuures han he number of midpoin quoes in he spo marke; while for he Yen marke, he number of midpoin quoes is higher in he spo marke. A he firs look, his resul on he Euro is surprising given he general noion ha he spo marke is much larger han he fuures marke. The resul is also consisen wih Rosenberg and Traub (2007) who found ha here are more fuures rades during regular fuures rading hours han ha in he spo marke. Moreover, we only consider regular fuures rading hours on he CME Globex (8:20 a.m. o 3:00 p.m. Easern ime), and his ime period does no fully overlap wih some of he imes of heavy volume in he spo marke. On he oher hand, in our daa, he EBS mid-quoes beween bid and ask poins are used for he spo marke, bu acual ransacion prices are used for boh fuures markes. Given ha muliple ransacions can 6

9 occur a he same quoe, he use of midpoin quoe would imply ha here are far more acual ransacions in he spo markes han indicaed by he number of observaions on Table 2. The higher number of daily average rades in he regular fuures marke does no exend o he E-mini fuures marke. Trading aciviy in he E-mini fuures markes is significanly lower han eiher of he oher wo markes considered here. In paricular, he Yen/US$ E-mini fuures conrac has a relaive exreme low rading frequency wih 42 rade per day on average over he sample period. Hence, he E-mini Yen fuures ime series is dropped from he presen analysis because of he very low number of observaions wihin a day. This low rading frequency prevens he convergence of our esimaion mehod resuling in considerably unreliable parameer esimaes and price discovery measures. As he correlaion coefficien marix shows, he series are highly correlaed. An excepion is he correlaion beween he E-mini conrac and he oher wo insrumens in he Yen/US$ marke. This correlaion is paricularly low, due o infrequen rading in he E-mini Yen fuures marke. EMPIRICAL RESULTS Based on he sandard Augmened Dickey-Fuller uni roo es, he null hypohesis of a uni roo canno be rejeced for any price series under sudy. The Johansen (1991) coinegraion es resuls show ha he spo exchange rae, he regular fuures, and he E-mini fuures in he Euro/US$ markes are coinegraed wih wo coinegraion relaionships. Similarly, here is one coinegraing vecor beween regular fuures and spo markes for he Yen/US$ series. Hence, he resuls confirm ha prices in he wo or hree foreign exchange markes share one common sochasic rend or efficien price. 5 Given hese saisical resuls, i is appropriae o proceed wih he price discovery analysis. 7

10 Two sandard approaches are used o examine he relaive raes of price discovery: (1) Informaion shares and (2) Gonzalo-Granger common facor weighs. Boh approaches assume ha an underlying securiy rading in muliple markes has a common implici efficien price. We also furher supplemen he analysis wih he error correcion adjusmen approach as used in Eun and Sabherwal (2003). Also noe ha he paper s resuls repored below remain significan when oher ime inervals (1 second, 10 seconds, 30 seconds and 1 minue) are considered in he esimaion of he model. All he esimaions are conduced on daily basis and closely follow ha of Hasbrouck (2003). Informaion Share (IS) approach The informaion share approach proposed by Hasbrouck (1995) decomposes he price series ino a random walk componen and a saionary componen. The random-walk componen represens he securiy s efficien price which is common o all markes, while he saionary erm capures marke-specific characerisics. Sudying he properies of his common componen is he goal of his measure. In paricular, Hasbrouck (1995) decomposes he variance of he common efficien price (random walk) innovaions. The porion of he variance explained by each marke is called he informaion share of marke j. The informaion share measures he porion of a subse of he marke s informaion ha is impounded ino prices by differen markes rading he same underlying securiy. The marke wih he larges informaion shares leads he oher markes by reacing o new informaion firs. If he innovaions in a marke drive he reacion of he oher markes, hen his marke is informaionally dominan. The Sock and Wason (1988) common rends represenaion of he model is as follows: p 0 + ( ε i ) ι + Ψ i= 1 = p ψ ( L) ε (1) 8

11 where p 0 is a consan n-vecor and Ψ (L) is a marix polynomial in he lag operaor. More specifically, he firs erm on he righ-hand side of equaion (1) is a vecor of iniial values ha may reflec non-sochasic differences beween he price variables. The second erm is he produc of a scalar random walk and a uni vecor, which capures he random walk componen ha is common o all prices (he efficien price). Alhough his componen is unobservable wihou furher idenificaion resricions, is innovaions have he propery ha hey are linear in he disurbances. The hird erm in equaion (1) is a zero-mean covariance saionary process. Define and noe ha ψ represens he common row vecor of Ψ (1). If n = 3, hen var( ψε 2 2 ) J1 σ 11 + J 2σ 22 + = J σ (2) where J i are he elemens in Ψ (1). Each of hese erms represens he conribuion o he random-walk innovaion from a paricular marke. The proporion of his for marke j (for j = 1, 2, 3) relaive o he oal variance is defined as he marke s j informaion share: IS j 2 ψ j Ω jj = or ψ Ω ψ IS j = J 2 1 σ 11 J + J 2 j 2 2 σ σ jj 22 + J 2 3 σ 33 where Ω is he covariance marix. The measure in he above equaion is oo resricive since price innovaions are generally correlaed across markes rading he same underlying insrumen. If he price innovaions are correlaed (i.e. σ ij 0 for i j), no unique values may be found for he informaion shares, and riangularizaion of he covariance marix may be used o esablish upper and lower bounds. 6 Therefore, when he covariance marix Ω is no diagonal, Hasbrouck (1995) defines he informaion shares of he marke j prices as 2 ([ ψf] j ) IS j = (3) ' ψωψ In his equaion, F is he Cholesky facorizaion of Ω, and a lower riangular marix such ha 9

12 ' Ω = FF 2. The variance aribued o a paricular marke j is ([ ψ F] j ) and [ψ F] j is he jh elemen of he row marix ψ F. The lower riangular facorizaion maximizes he informaion shares on he firs price. By permuing he order of he marke prices, equaion (3) will provide an upper and lower bound for he informaion share of each marke. Table III presens esimaes relaing o he informaion shares and he correlaions of he price innovaions. Due o he presence of nonzero off-diagonal correlaions in he innovaions, only upper and lower bounds for he informaion shares can be esablished. Care mus be exercised in inerpreing he lower and upper bounds since hey do no provide a single measure of informaion share. However, following Booh e al. (2002) and many ohers, he midpoins of lower and upper bounds can be used as a unique measure of he price discovery conribuion. The informaion share saisics reflec he average of all daily esimaes. Panel A of Table III shows ha he Euro/US$ spo marke conribues he mos o price discovery, accouning roughly for over 60% of he informaion share. The oher wo prices share he remainder, wih he regular fuures accouning for 33% and he E-mini fuures accouning for comparable shares on average. In he Yen/US$ marke, he spo rades lead he price discovery process wih roughly 75% of he informaion share, while he regular fuures conribues only abou 25% of price discovery. The findings confirm he recen work of Tse, Xiang and Fung (2006) on Yen as hey provide evidence ha he Yen spo foreign exchange marke dominaes he fuures markes in price discovery. However, he findings conradic ha of Rosenberg and Traub (2007) who find regular fuures conribue more o he price discovery in Also in conras wih he evidence in he equiy markes, he resuls show ha he E-mini fuures do no dominae he price discovery process in foreign exchange markes. The finding may no be surprising, given relaively low number of rades on he E-mini fuures marke in Table II. As furher poined ou by he referee, alhough he E-mini currency fuures marke is a global marke, 10

13 i s raher concenraed among a few banks. Thus, here migh no be many informed raders in his marke. Panel A and B in Figure 1 presen he ime series of he daily informaion shares of he hree Euro/US$ insrumens and he wo Yen/US$ insrumens respecively. The informaion share midpoins are shown. Despie some ime variaions, i is clear ha he spo markes consisenly dominae he fuures markes over he sample period. 7 These findings hold for boh currency markes. I can also be seen ha in he Euro/US$ marke, here is no informaion dominance of he E-mini fuures marke over he regular fuures. Overall, hese resuls provide evidence ha he spo marke is he major conribuor o price discovery in foreign exchange markes over ime. Common facor componen weigh (GG) approach Le p be a (n x 1) vecor of I(1) price series for he same underlying securiy in n markes. Even hough each individual price series is non-saionary, hey are coinegraed wih h (h = n-1 in his sudy) coinegraing relaions. The Granger represenaion heorem shows ha he VAR(p) wih coinegraed variables can be wrien in is error-correcion form * Δ p = Bz 1 + 1Δp 1 + ς 2Δp 2 + ς 3Δp ς p 1Δp p+ 1 ς + ε Sock and Wason (1988) shows ha he price vecor can be decomposed ino a permanen and a ransiory componen. Gonzalo and Granger (1995) propose an alernaive decomposiion of p where he permanen componen will be a funcion of he curren values of p (which differs from he Sock and Wason (1988) represenaion where he common rend is a funcion of he curren and lagged values of he disurbances and herefore of p ). 8 The vecor of prices p is decomposed as follows, p = F f 1 + F τ 2 where: f = common long memory componen (vecor of common sochasic rends) 11

14 τ = saionary componen Two condiions are imposed: (i) f is an exac linear funcion of he curren values of p (ii) The ransiory componen, τ, has no permanen effec on p These assumpions or condiions make i possible o idenify he common facor and also make he common efficien price f observable (a funcion of he curren values of he price vecor). In oher words, he Gonzalo-Granger approach defines he permanen componen of he vecor of prices p as a linear combinaion of he curren values of he price vecor iself, where he linear combinaion is given by he srucure of he A *. A * is a marix orhogonal o he marix of coinegraing vecors A, and can be esimaed as a marix of (n - h) eigenvecors using he Johansen (1991) procedure. Given he naure of he Gonzalo- Granger decomposiion and he following resul: f = A ' * p he A * marix (afer normalizaion) becomes a naural measure of he conribuion o price discovery of marke i. The higher he weigh, he larger he conribuion of he marke o he informaion impounding process is. There is no resricion in he decomposiion procedure which prevens he facor weighs from being negaive. Since he size (no he sign) of he weighs provide a measure of he marke's role in he price discovery process, he weighs are normalized so ha hey come ou o be posiive and he sum of hese weighs is equal o one, ' ' ω = ( abs( A ) ι) * 1 ' abs( A ) where abs (.) denoes he absolue value of each elemen in he marix and ι is (nx1) vecor of ones. Table IV provides he summary saisics of he common facor weighs for each marke price in he model. The firs half of each panel presens he common-facor * 12

15 coefficiens obained by he Gonzalo and Granger (1995) mehod, and he second half presens he normalized coefficiens or weighs. 9 In panel A for he Euro, he daily average of he normalized common-facor weighs is evidence of a predominan price discovery role of he spo markes. On average, he spo price conribues 60% of he formaion of he common-facor componen or efficien price. The oher wo prices share he remainder, wih he regular fuures conribuing 23% and he E-mini fuures markes conribuing 17%. Anoher ineresing observaion is ha he able under Min, boh he regular and he E-mini fuures prices show no conribuion o price discovery in some of he sample days. Panel B shows similar resuls for he Yen/US$ markes. The common facor weigh for he regular fuures markes (28%) is much smaller han ha of he spo marke. Furhermore, compared wih he case of he Euro, leaving ou he E-mini from he analysis for he Japanese Yen has increased he spo weigh by a much larger percenage han he increase in he regular fuures weigh. This could imply ha he spo prices may beer capure he price informaion revealed in he E-mini marke han he regular fuures marke does. Panel A and B in Figure 2 presen he ime series behavior of he daily esimaed Gonzalo-Granger common facor weighs over he sample period. The esimae for he spo series is mean revering around a poin higher han 50% in boh currency markes. These resuls are obviously consisen wih he resuls in Table IV. In summary, in line wih he informaion share resuls, he resuls here suppor he findings of he dominance of spo marke over boh he regular and E-mini fuures markes and almos equal performance of he regular fuures and E-mini fuures in he foreign exchange marke price discovery. Error-correcion adjusmen approach We furher conduc weak exogeneiy ess for each exchange rae series based on an error correcion model. The idea is ha alhough here is one common sochasic rend for he exchange raes on relaed spo and fuure markes, hese exchange raes may have emporary 13

16 deviaion from he common rend due o various marke fricions. Such exchange rae dynamics across relae markes can be modeled in an error correcion model wih n - 1 coinegraing relaions (or n - 1 error correcion erms) for n exchange raes: * Δ p = Bz p 1 + ς 2 p ς p 1 p p+ 1 ς + ε where B is he (n x (n 1)) marix of adjusmen coefficiens and he error correcion erms in * z 1 can be specified using wo price differenials involving he spo prices. Specifically, for n = 3, Bz * 1 b = b b b b b ( p ( p 1 1 p p 2 3 ) μ 2 ) μ3 where μ i is he average price differenial or mean deviaion for i = 2, 3. The coefficiens for he error correcion erms (or so-called adjusmen coefficiens, given by he B marix) measure he adjusmen speeds by which each variable adjuss iself oward he long-run equilibrium. As poined ou in Eun and Sabherwal (2003), he magniude of adjusmen coefficiens can be used o assess he conribuion of a paricular marke o price discovery. A marke which has zero (i.e., weakly exogenous) or a smaller (in absolue value) adjusmen coefficien han hose of oher markes is a more dominan source of informaion in he price discovery process in he long run. Esimaed adjusmen coefficiens of he error correcion models (Table V) furher confirm our resuls. As shown in Panel A, here are wo findings worh noing for he Euro/US$. Firs, on average, he coefficien esimaes on he spo error-correcion erms are no significan a he 0.05 level and hus weakly exogenous, while he esimaes on he regular fuures and E-mini fuures error correcion erms are significan a he 0.01 and 0.05 levels, respecively. Second, on average, he absolue values of he adjusmen coefficien esimaes are higher for he fuures markes relaive o he spo marke. The resuls sugges 14

17 ha error-correcing adjusmens o price differenials occur mainly in he regular fuures and E-mini fuures markes, which is in line wih he leading price discovery role of he spo marke. Panel B provides very similar resuls o hose in Panel A. The Yen/US$ regular fuures markes provide saisically significan adjusmen coefficien esimaes wih a magniude (in he absolue value) larger han he esimaes for he spo marke. Therefore, similarly o he Euro/US$ marke, error correcing adjusmens o price differenials also occur mainly in he fuures markes. In summary, he resuls confirm ha he spo marke leads he regular fuures and E-mini fuures markes in he price discovery process. Figure 3 furher presens he ime plos of -saisics of he adjusmen coefficien esimaes for boh currencies. Consisen wih he resuls in Table V, hese graphs reveal ha over he majoriy of rading days, i is primarily he fuures markes raher han he spo markes ha adjus o price differenials across markes. CONCLUSIONS Given much recen evidence of he superioriy of elecronic rading, i is ineresing o ask he quesion: among hese markes rading elecronically, which one leads he price discovery process? This paper aemps o answer his quesion on he foreign exchange marke. Using inra-day (ick by ick) daa, his paper invesigaes he conribuion o he price discovery on he Japanese Yen and he Euro exchange raes of hree elecronically raded foreign exchange markes: he CME elecronically-raded GLOBEX regular fuures, elecronically-raded small-denominaion fuures (E-Minis), and he iner-dealer spo marke. The resuls show ha ransacion prices in he iner-dealer spo foreign exchange marke are more informaive han he prices in boh he regular fuures and he E-mini fuures markes and hus he spo foreign exchange marke leads he price discovery process for boh exchange raes during he sample period. 15

18 The findings of his sudy are jusifiable by he sheer size of he inerdealer spo marke compared wih he fuures markes and he use of EBS inerdealer currency spo daa as EBS has become he major rading plaform for boh he Yen and he Euro. However, he resuls sand in sharp conras o recen sudies ha currency fuures markes migh lead he currency spo markes in price discovery. In paricular, alhough his sudy confirms he recen finding of Tse, Xiang and Fung (2006) in favor of he spo markes for he Yen, he finding on he Euro here conradics ha of Tse, Xiang and Fung (2006). Neverheless, he resul of Tse e al. (2006) migh no be very surprising given he fac ha heir spo rae daa are from he CMC reail plaform, which is unlikely o have informed raders. The overall findings of his sudy are also only parially in line wih ha of Rosenberg and Traub (2007). Ineresingly, while Rosenberg and Traub (2007) found currency fuures marke can lead he spo marke in price discovery using he inerdealer spo ransacions from he Reuers Dealing sysem from May o Augus 1996, hey also repor ha he spo marke leads fuures marke using spo marke quoes from Bloomberg over he period from March o May A possible explanaion for heir resul is ha greaer ransparency is generally associaed wih more informaive prices (Madhavan, 2000). A marke wih low ransparency is ypically associaed wih lower degree of price discovery. As poined ou by Rime (2003), he inerdealer direc rading plaform by Reuers Dealing has a relaively low level of price ransparency. However, he spo marke migh have become more ransparen over ime. Hence, i migh no be surprising ha based on he daa from 1996, he fuures marke leads he spo marke in price discovery, while using he daa from 2006, he spo marke leads he fuures marke as he spo marke becomes more ransparen. Neverheless, as discussed earlier, our findings based on he EBS daase should be mos relevan and represenaive for he wo exchange raes under consideraion. Furhermore, we also find elecronically raded regular fuures (on average) 16

19 conribue (a bi) more han he E-mini fuures and he E-mini fuures (on average) conribue he leas o he price discovery in he Euro/US$ and he Yen/US$ markes (while he spo marke conribues he mos). The finding is conradicory o he finding on he role of E-mini fuures in he equiy markes (e.g., Hasbrouck, 2003; Kurov and Lasser, 2004; Aes and Wang, 2005). Finally, fuure research may gain furher insigh by considering he role of order flow in he price discovery process in foreign exchange markes, as suggesed by Evans and Lyons (2002). Given he fac ha mos sudies using high frequency daa are limied o sample periods spanning only a few monhs, i may also be an area of fruiful research o explore poenial ime variaion in conribuions of each marke o he price discovery process by using a longer period of inraday daa. 17

20 BIBLIOGRAPHY Aes, A, & Wang, G. H. K. (2005). Informaion ransmission in elecronic versus open-oucry rading sysems: An analysis of U.S. equiy index fuures markes. Journal of Fuures Markes, 25, Aes, A, & Wang, G. H. K. (2006). Liquidiy and he evoluion of price discovery on floor versus screen-based rading sysems: An analysis of he foreign exchange fuures markes. Financial Managemen Associaion Annual Meeings. Booh, G. G., Lin J-C., Marikainen T., & Tse Y. (2002). Trading and pricing in upsairs and downsairs sock markes. Review of Financial Sudies, 15, Chaboud, A., S. Chernenko, E. Howorka, R. S. Krishnasami Iyer, D. Liu, & J. Wrigh (2004). The high-frequency effecs of U.S. macroeconomic daa releases on prices and rading aciviy in he global inerdealer foreign exchange marke. Federal Reserve Board s Inernaional Finance Discussion Papers No De Jong, F.(2002). Measures of conribuion o price discovery: A comparison. Journal of Financial Markes, 5, Eun, C.S., Sabherwal, S. (2003). Cross-border lisings and price discovery: Evidence from US-lised Canadian socks. Journal of Finance, 58, Evans M.D.D. (2002). FX rading and exchange rae dynamics. Journal of Finance, 57 (6), Evans, M. D. D., Lyons, R. K. (2002). Order flow and exchange rae dynamics. Journal of Poliical Economy, 110, Gonzalo, J. & Granger, C.W.J. (1995). Esimaion of common long-memory componens in coinegraed sysems. Journal of Business & Economic Saisics, 13, Hasbrouck, J. (1995). One securiy, many markes: Deermining he conribuion o price discovery. Journal of Finance, 50,

21 Hasbrouck, J. (2003). Inraday price formaion in U.S. equiy index markes. Journal of Finance, 58, Johansen, S. (1991). Esimaion and hypohesis esing of coinegraion vecors in Gaussian vecor auoregressive models. Economerica, 59, Kurov, A., & Lasser, D. J. (2004). Price dynamics in he regular and E-mini fuures markes. Journal of Financial and Quaniaive Analysis, 39, Lyons, R. K. (2001). The Microsrucure approach o exchange raes. MIT press, Cambridge. Madhavan, A., (2000). Marke microsrucure: a survey, Journal of Financial Markes, 3, Rime, D. (2003). New elecronic rading sysems in foreign exchange markes, in Derek C. Jones, ed.: New Economy Handbook (Elsevier). Rosenberg, J. & L. G. Traub (2007). Price discovery in he foreign currency fuures and spo marke. Federal Reserve Bank of New York, working paper. Sock, J. H., & Wason, J. W. (1988). Tesing for common rends. Journal of he American Saisical Associaion, 83, Tse, Y., Xiang, J., & Fung, J. K. W. (2006). Price discovery in he foreign exchange fuures markes. Journal of Fuures Markes, 26,

22 Table I Trading Saisics on CME Fuures Globex ADV 7:05am - 4:00pm Globe x ADV 5:00p m - 7:05p m Globe x ADV 5:00p m - 4:00p m Floor ADV Globe x Day Globe x 7:20am - 2:00pm % of % of Globe Toal x Tradin Toal g Symbol Type Trading (conrac s) (conra cs) (conra cs) (conracs) E- E7 (Euro) Mini Globex EC Regula Pi & (Euro) r Globex E- J7 (Yen) Mini Globex Regula Pi & JY (Yen) r Globex Noe: 1. ADV is he Average Daily Volume. 2. "Day" = 7:05am - 4:00pm. 3. Percenages are also period averages. 4. Sample period is from April 4h, 2005 o July 29h,

23 Table II Summary Saisics (daily averages) Euro Spo Regular fuures E-mini fuures Number of observaions Mean Sandard Deviaion Skewness Kurosis Japanese Yen Spo Regular fuures E-mini fuures Number of observaions Mean Sandard Deviaion Skewness Kurosis Correlaion coefficiens for he prices (daily averages) Euro Spo Regular fuures E-mini fuures Spo Regular fuures E-mini fuures 1 Japanese Yen Spo Regular fuures E-mini fuures Spo Regular fuures E-mini fuures 1 Noe: Sample period is from April 4h, 2005 o July 29h,

24 Table III Informaion Shares Panel A: Euro Informaion Shares Spo Trade Regular Conrac E-Mini Conrac Price Price Price Ma Min Mid Max Min Mid Max Min Mid x Median Mean Sd. Dev Disurbance Correlaion Marix Spo Trade Regular Conrac E-Mini Conrac Price Price Price Spo Trade Price Regular Conrac Price E-Mini Conrac Price Panel B: Japanese Yen Informaion Shares Spo Trade Price Regular Conrac Price Min Mid Max Min Mid Max Median Mean Sd. Dev Disurbance Correlaion Marix Spo Trade Regular Conrac Price Price Spo Trade Price Regular Conrac Price 1 22

25 Table IV Gonzalo-Granger Facor Weighs Panel A: Euro Gonzalo-Granger Common Facor Weighs E-mini fuures Spo Regular Fuures Mean Min Max Sd. Dev Gonzalo-Granger Common Facor Weighs (Normalized) E-mini fuures Spo Regular Fuures Mean Min Max Sd. Dev Panel B: Japanese Yen Gonzalo-Granger Common Facor Weighs Spo Regular Fuures Mean Min Max Sd. Dev Gonzalo-Granger Common Facor Weighs (Normalized) Spo Mean Min Max Sd. Dev Regular Fuures 23

26 Table V VECM Esimaion Resuls Adjusmen Coefficiens Panel A: Euro b i,2 Spo Regular Fuures E-mini fuures Mean [-1.54] [5.00] [-2.20] Min [-3.64] [1.52] [-4.91] Max [0.64] [11.18] [1.01] b Spo Regular Fuures E-mini fuures Mean [-0.47] [-0.82] [5.17] Min [-2.85] [-3.71] [2.47] Max [2.00] [1.57] [8.55] Panel B: Japanese Yen b Spo Regular Fuures Mean [-1.76] [5.04] Min [-4.43] [2.35] Max [1.00] [9.11] i,3 i,2 24

27 Panel A: Euro/$ Panel B: Japanese Yen/$ Figure 1 25

28 Panel A: Euro/$ Panel B: Japanese Yen/$ Figure 2 26

29 Panel A: Euro/$ Panel B: Japanese Yen/$ Figure 3 27

30 Foonoes 1 In he revised version of he paper, Rosenberg and Traub (2007) augmened heir resuls using he spo marke quoes from Bloomberg over a hree-monh period in They found ha he spo marke dominaed price discovery. 2 Currenly, wo elecronic brokering sysems are used globally for inerdealer spo rading, one offered by EBS and he oher offered by Reuers Dealing Euro/US$ and yen/us$ are raded primarily on EBS while serling/us$ is raded mainly on Reuers (see Chaboud, Chernenko, Howorka, Krishnasami-Lyer, Liu, & Wrigh, 2004). 3 No all rading days wihin he four-monh sample period have been used in his sudy. Several days have been excluded from he esimaion due o he lack of rading aciviy in all markes simulaneously. July 4h and July 11h hrough July 15h have been excluded since no all markes are open o rade on hese days, and he economeric echniques rely on having a sufficien number of observaions for all insrumens for all days. 4 The regular floor rading daa during he sample period were also obained. However, he floor rading is very infrequen compared wih elecronic rading (see Table I), hus he floor rading daa are no used in he analysis, even hough he analysis is resriced o he period of he floor rading hours. 5 The resuls are available upon reques. 6 Tables III presens he average mean disurbance (price innovaion) correlaion marix for he Euro/US$ and he Yen/US$. respecively. The riangularizaion is implemened since he off-diagonal erms are differen from zero. 7 For a few days during he sample period, he informaion shares of regular fuures marke are larger han hose in he spo marke wih increasing ransacions for boh spo and fuures markes. This swich in he relaive imporance of he informaion shares on spo and fuures markes also someimes coincides wih he days wih some idenifiable economic news. Neverheless, he exac reason why such swich occurs is no clear and worhy of pursuing in he fuure research. 8 De Jong (2002) provides a deailed discussion abou he relaionship beween he Gonzalo-Granger common facor coefficiens and he Sock and Wason (1988) decomposiion. 9 This normalizaion was necessary o simplify he inerpreaion of he common-facor coefficiens as measures of price discovery. Afer normalizing, he coefficiens are all posiive beween 0 and 1 and hey sum o one. 28