On Uncertainty, Market Timing and the Predictability of Tick by Tick Exchange Rates

46 Pages Posted: 23 May 2008

See all articles by Roman Kozhan

Roman Kozhan

University of Warwick - Warwick Business School

Mark Salmon

University of Cambridge - Faculty of Economics and Politics

Date Written: August 2008

Abstract

This paper examines the predictability of exchange rates on a transaction level basis using both past transaction prices and the structure of the order book. In contrast to the existing literature we also recognise that the trader may be subject to (Knightian) uncertainty as opposed to risk regarding the structure by which exchange rates are determined and hence regarding both the model he employs to make predictions and the reliability of any conditioning information. The trader is faced with a two stage decision problem due to this uncertainty; first he needs to resolve a question of market timing as to when to enter the market and then secondly how to trade. We provide a formalisation for this two stage decision problem. Statistical tests indicate the significance of theory of sample ability to predict directional changes and the economic value of predictability using one week of tick-by-tick data on the USD-DM exchange rate drawn from Reuters DM2002 electronic trading system. These conclusions rest critically on the frequency of trading which is controlled by an inertia parameter reflecting the degree of uncertainty; trading too frequently significantly reduces profitability taking account of transaction costs.

Keywords: Knightian uncertainty, market timing, predictability, high-frequency data

JEL Classification: D81, F31, C53

Suggested Citation

Kozhan, Roman and Salmon, Mark Howard, On Uncertainty, Market Timing and the Predictability of Tick by Tick Exchange Rates (August 2008). WBS Finance Group Research Paper No. 101, Available at SSRN: https://ssrn.com/abstract=999850 or http://dx.doi.org/10.2139/ssrn.999850

Roman Kozhan

University of Warwick - Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

Mark Howard Salmon (Contact Author)

University of Cambridge - Faculty of Economics and Politics ( email )

Austin Robinson Building
Sidgwick Avenue
Cambridge, CB3 9DD
United Kingdom

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