On uncertainty, market timing and the predictability of tick by tick exchange rates

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 out 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