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Carry Trades, Order Flow and the Forward Bias Puzzle

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “Carry Trades, Order Flow and the Forward Bias Puzzle,” authored by Francis Breedon, Dagfinn Rime, and Paolo Vitale, delves into the intricate relationship between foreign exchange (FX) order flow and the forward bias.

The study presents a novel decomposition of the forward bias, elucidating a negative correlation between interest rate differentials and order flow, resulting in a time-varying risk premium consistent with the observed bias.

Leveraging ten years of FX order flow data, the findings suggest that over half of the forward bias can be attributed to order flow, with the remainder being explained by expectational errors. Moreover, the research unveils that carry trading amplifies currency-crash risk, manifesting as negative skewness in FX returns.

This nuanced analysis sheds light on the multifaceted interplay between order flow, risk premia, and the forward bias, offering valuable insights into the microstructure of FX markets and the implications for carry trade strategies and currency risk dynamics.

Abstract Of Paper

We investigate the relation between foreign exchange (FX) order flow and the forward bias. We outline a decomposition of the forward bias according to which a negative correlation between interest rate differentials and order flow creates a time-varying risk premium consistent with that bias. Using ten years of data on FX order flow we find that more than half of the forward bias is accounted for by order flow — with the rest being explained by expectational errors. We also find that carry trading increases currency-crash risk in that order flow generates negative skewness in FX returns.

Original paper – Download PDF

Here you can download the PDF and original paper of Carry Trades, Order Flow and the Forward Bias Puzzle.

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Author

Francis Breedon
University of London, Queen Mary – School of Economics and Finance

Dagfinn Rime
BI Norwegian Business School

Paolo Vitale
G. d’Annunzio University – Dipartimento di Economia

Conclusion

The elucidation of the complex interrelationships between FX order flow, risk premia, and the forward bias presented in the research paper significantly advances our understanding of FX market dynamics and the implications for carry trade strategies.

The findings highlighting the substantial contribution of order flow to the forward bias and the amplification of currency-crash risk by carry trading offer valuable insights for market participants and policymakers.

The decomposition of the forward bias, shedding light on the critical role of interest rate differentials and order flow, paves the way for a nuanced understanding of the underlying microstructure of FX markets, emphasizing their susceptibility to carry trade and the associated risk dynamics.

These insights prompt a reevaluation of trading strategies and risk management practices in FX markets, given the intricate relationship between order flow, forward bias, and risk dynamics.

Related Reading:

Price Overreactions in the Forex and Trading Strategies

A Liquidity-Based Resolution of the Uncovered Interest Parity Puzzle

FAQ

Q1: What is the main focus of the research paper “Carry Trades, Order Flow and the Forward Bias Puzzle” by Francis Breedon, Dagfinn Rime, and Paolo Vitale?

A1: The main focus of the research paper is to investigate the relationship between foreign exchange (FX) order flow and the forward bias. The study presents a novel decomposition of the forward bias, revealing a negative correlation between interest rate differentials and order flow, leading to a time-varying risk premium consistent with the observed forward bias.

Q2: How does the research decompose the forward bias, and what does it find regarding the contribution of order flow to the forward bias?

A2: The research decomposes the forward bias, suggesting that a negative correlation between interest rate differentials and order flow creates a time-varying risk premium consistent with the observed bias. Using ten years of FX order flow data, the findings reveal that more than half of the forward bias is accounted for by order flow, while the remainder is explained by expectational errors.

Q3: What does the research uncover regarding the relationship between carry trading and currency-crash risk?

A3: The research uncovers that carry trading increases currency-crash risk. Specifically, it finds that order flow generates negative skewness in FX returns, emphasizing the role of carry trading in amplifying the risk of currency crashes. This insight has implications for understanding the dynamics of FX markets and the risks associated with carry trade strategies.

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