Futures trading activity and predictable foreign exchange market movements

Abstract

In this paper, we examine the relation between futures trading activity by trader type and returns over short horizons in five foreign currency futures markets - British pound, Canadian dollar, Deutsche mark, Japanese yen, and Swiss franc. Transforming trading activity into a sentiment measure, we find that speculator sentiment is positively related to future returns. In contrast, hedger sentiment covaries negatively with future returns. We also find that extreme sentiment by trader type is more correlated with future market movements than moderate sentiment. Our results suggest that hedgers lose to speculators in these futures markets, on average. Based on equilibrium pricing models that futures risk premiums are determined by both market risk and hedging pressure, we show that the profits to speculators are in general compensation for bearing risk. © 2003 Elsevier B.V. All rights reserved.