Heterogeneous Real-Time Trading Strategies in the Foreign Exchange Markets

Abstract

The foreign exchange (FX) market is worldwide, but the dealers differ in their geographical locations (time zones), working hours, time horizons, home currencies, access to information, transaction costs, and other institutional constraints The variety of time horizons is large: from intra-day dealers, who close their positions every evening, to long-term investors and central banks. Depending on the constraints, the different market participants need different strategies to reach their goal, which is usually maximizing the profit, or rather a utility function including risk. Different intraday trading strategies can be studied only if high-density data is available. Olsen & Associates (O&A) has collected and analyzed large amounts of FX quotes by market makers around the clock (up to 5000 nonequally spaced prices per day for the German mark against the US$). Based on this data, a set of real-time intraday trading models has been developed. These models give explicit trading recommendations under realistic constraints. They are only allowed to trade during the opening hours of a market, depending on the time zone and local holidays. The models have been running real-time for more than three years, thus leading to an ex-ante test. The test results, obsure, are presented. All these trading models are profitable, but they differ in their risk behavior and dealing frequency. If a certain profitable intraday trading algorithm is tested with different working hours,its success can considerably change. A systematic study shows that the best choice of working hours is usually when the most important markets for the particular FX rate are active. All the results demonstrate that the assumption of a homogeneous 24-hour FX market with identical dealers, following an identical "rational expectation", is far from reality. To explain the market dynamics, a hetero-geneous model of the market with different types of dealers is more appropriate.

JEL Classification: F31, G14