RFS Advance Access originally published online on August 27, 2007
Review of Financial Studies 2007 20(6):1975-2019; doi:10.1093/rfs/hhm034
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Informed and Strategic Order Flow in the Bond Markets
Ross School of Business, University of Michigan
Simon School of Business, University of Rochester and FRBG
Address correspondence to Paolo Pasquariello, Ross School of Business, University of Michigan, 701 Tappan Street, Room E7602, Ann Arbor, MI 48109-1234, or e-mail: ppasquar{at}bus.umich.edu and Clara.Vega{at}frb.gov
JEL: E44, G14
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Abstract |
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We study the role played by private and public information in the process of price formation in the U.S. Treasury bond market. To guide our analysis, we develop a parsimonious model of speculative trading in the presence of two realistic market frictions—information heterogeneity and imperfect competition among informed traders—and a public signal. We test its equilibrium implications by analyzing the response of two-year, five-year, and ten-year U.S. bond yields to order flow and real-time U.S. macroeconomic news. We find strong evidence of informational effects in the U.S. Treasury bond market: unanticipated order flow has a significant and permanent impact on daily bond yield changes during both announcement and nonannouncement days. Our analysis further shows that, consistent with our stylized model, the contemporaneous correlation between order flow and yield changes is higher when the dispersion of beliefs among market participants is high and public announcements are noisy.
The authors are affiliated with the Department of Finance at the Ross School of Business, University of Michigan (Pasquariello) and the University of Rochester, Simon School of Business and the Federal Reserve Board of Governors (Vega). We are grateful to the Q Group for financial support. We benefited from the comments of an anonymous referee, Sreedhar Bharath, Michael Brandt, Michael Fleming, Michael Goldstein, Clifton Green, Joel Hasbrouck (the editor), Nejat Seyhun, Guojun Wu, Kathy Yuan, and other participants in seminars at the 2005 European Finance Association meetings in Moscow, the 2006 Bank of Canada Fixed Income Markets conference in Ottawa, the 2007 American Finance Association meetings in Chicago, Federal Reserve Board of Governors, George Washington University, the University of Maryland, the University of Michigan, the University of Rochester, and the University of Utah. Any remaining errors are our own.
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