Foreign investor feedback trading in an emerging financial market

Summary

Focus

We study the relationship between the trading behaviour of foreign investors, different types of local investors and returns in foreign exchange, fixed income and equity markets of an emerging market economy (EME). We investigate which strategy best explains foreign investor trading behaviour, whether foreign investors bring unique information to local financial markets, and what impact they have on local asset returns and local investor trading.

Contribution

We contribute to the literature that tests for the relationship between order flow and returns. We examine differences between trading behaviour of foreign investors and different types of local investors, their impact on prices, their information sets and their trading strategies. We also contribute to the literature that attempts to identify and explain the apparent violations of an efficient market hypothesis, specifically the existence of the momentum anomaly – that is, investors' ability to generate abnormal returns by exploiting the tendency of rising asset prices to keep rising, and falling prices to keep falling. In doing so, we rely on a comprehensive data set of buy and sell trading volumes of different investor types in Thai financial markets covering a long time sample. The analysis is conducted using measures of net order flow that have been aggregated and normalised, and there is no reference to actual trading volumes.

Findings

We find that foreign investors engage in momentum trading, which reinforces positive feedback between the direction of trading and returns. The returns to momentum trading appear to increase with the amount of foreign capital flowing into local financial markets. Innovations in foreign investor order flow also predict future returns, which suggests that they bring new information to local financial markets. Local financial investors tend to follow foreign investors in the same direction, but with a lag, while local non-financial investors provide liquidity as counterparties. These findings point at mispricing opportunities that can be exploited by some investors. In particular, periods of persistent returns to momentum trading appear to be exploited by foreign and a subset of local financial investors.

Abstract

This paper finds that trading by non-residents in an emerging financial market reinforces the existence of a momentum anomaly, in an apparent violation of an efficient market hypothesis. Using detailed order flow data in Thai foreign exchange, equity, and fixed income markets, we find that foreign investors engage in momentum trading, which amplifies positive feedback between returns and order flow across all asset classes. Innovations in foreign investor order flow are informative of future returns, but the information is not based on local macro fundamentals. Local financial investors tend to mimic foreign investor trading, reinforcing returns to momentum, while non-financial investors consistently provide liquidity. Further tests suggest that the returns to momentum trading are time-varying and are positively related to the amount of foreign capital flowing into the local financial market. Taken together, the results indicate that a significant presence of foreign investors can alter the trading behaviour of local investors and can reduce the importance of local fundamentals in driving asset prices.

JEL classification: F30, G11, G14, G15

Keywords: international financial markets, heterogeneous trading, disaggregated order flow, foreign investors, emerging markets