Short-Run Exchange-Rate Dynamics: Theory and Evidence (original) (raw)

CREATES Research Paper 2008-1 Short-run Exchange-Rate Dynamics: Theory and Evidence

2008

Recent research has revealed a wealth of information about the microeconomics of currency markets and thus the determination of exchange rates at short horizons. This information is valuable to us as scientists since, like evidence of macroeconomic regularities, it can provide critical guidance for designing exchange-rate models. This paper presents an optimizing model of short-run exchange-rate dynamics consistent with both the micro evidence and the macro evidence, the first such model of which we are aware. With respect to microeconomics, the model is consistent with the institutional structure of currency markets, it accurately reflects the constraints and objectives faced by the major participants, and it fits key stylized facts concerning returns and order flow. With respect to macroeconomics, the model is consistent with most of the major puzzles that have emerged under floating rates. JEL classifications: F31, G12, G15.

The Microstructure of Currency Markets

2012

This paper describes the structure and microeconomics of the foreign exchange market. It begins by outlining the major participants and the instruments they trade, highlighting the vast institutional changes that accompanied the emergence of electronic trading since the 1990s. It then discusses how and why order flow drives exchange rates; the economics of liquidity provision; the price discovery process; and volatility. This paper was prepared as a chapter of Survey of International Finance, Kent Baker &

The microstructure approach to exchange rates: a survey from a central bank’s viewpoint

2005

5 1. Introduction 7 2. Key concepts of the microstructure approach to exchange rates 9 2.1. The macro-based approach to exchange rates 9 2.2. The characteristics of spot currency markets 10 2.3. Foreign exchange trading, order flow and information 12 2.4. The role of order flow in microstructure models 14 3. Theoretical models of market microstructure 16 3.1. The Kyle model 16 3.2. The Lyons-Evans model 20 4. The relationship between order flows and exchange rates: What does the data reveal? 23 5.5. Microstructure impacts in traditional macro models 37 6. Conclusions 38 References 39 MNB OCCASIONAL PAPERS 42. • 2005 3 Contents MNB OCCASIONAL PAPERS 42. • 2005 5

The market microstructure approach to foreign exchange: Looking back and looking forward

Journal of International Money and Finance, 2013

Research on foreign exchange market microstructure stresses the importance of order flow, heterogeneity among agents, and private information as crucial determinants of short-run exchange rate dynamics. Microstructure researchers have produced empirically-driven models that fit the data surprisingly well. But FX markets are evolving rapidly in response to new electronic trading technologies. Transparency has risen, trading costs have tumbled, and transaction speed has accelerated as new players have entered the market and existing players have modified their behavior. These changes will have profound effects on exchange rate dynamics. Looking forward, we highlight fundamental yet unanswered questions on the nature of private information, the impact on market liquidity, and the changing process of price discovery. We also outline potential microstructure explanations for long-standing exchange rate puzzles. JEL Classification: F31, G12, G15, C42, C82. 3 King et al. (2012) provides a comprehensive history of the evolution of FX market structure, with considerable detail on the geography and composition of currency trading, the players in FX markets, and the evolution of electronic trading. The chapter is descriptive and does not consider the microstructure literature or other academic studies of FX.

A New Micro Model of Exchange Rate Dynamics

2004

We address the exchange rate determination puzzle by examining how information is aggregated in a dynamic general equilibrium (DGE) setting. Unlike other DGE macro models, which enrich either preference structures or production structures, our model enriches the information structure. The model departs from microstructure-style modeling by identifying the real activities where dispersed information originates, as well as the technology by which information is subsequently aggregated and impounded. Results relevant to the determination puzzle include: (1) persistent gaps between exchange rates and macro fundamentals, (2) excess volatility relative to macro fundamentals, (3) exchange rate movements without macro news, (4) little or no exchange rate movement when macro news occurs, and (5) a structural-economic rationale for why transaction flows perform well in accounting for monthly exchange rate changes, whereas macro variables perform poorly. Though past micro analysis has made progress on results (1) through (3), results (4) and (5) are new. Excess volatility arises in our model for a new reason: rational exchange rate errors feed back into the fundamentals that the exchange rate is trying to track.

Traders, Market Microstructure and Exchange Rate Dynamics

SSRN Electronic Journal, 1999

We thank Helen Popper and Russ Root for useful comments, Eiji Fujii and Madhushree Dasgupta for research assistance, and the UCSC Document Publishing and Editing Center for logistical assistance in conducting the survey. The financial support of faculty research funds of the University of California is gratefully acknowledged. The views expressed herein are those of the authors and not necessarily those of the National Bureau of Economic Research.

Market Microstructure Approach to the Exchange Rate Determination Puzzle

The Iup Journal of Monetary Economics, 2009

The market microstructure approach has been applied to the three major puzzles of exchange rate economics: the forward bias puzzle, the excess volatility puzzle, and the exchange rate determination puzzle. It claims that the imbalances between 'buyer-initiated and seller-initiated trades' in foreign exchange markets are indicative of the transmission link between exchange rates and fundamental determinants of exchange rates. In the context of the exchange rate determination puzzle, this paper discusses the market microstructure approach from the stand point of hybrid models that integrate order flow, fundamentals and non-fundamental variables to establish the determinants of the rand-dollar exchange rate. Among the non-fundamentals considered is the Economist commodity price index, the relevance of which is based on Chen and Rogoff . Another non-fundamental variable included is a proxy for country risk-the differential between the Global Emerging Market Bond Index and the South African long-term bond.

Order Flow and Exchange Rate Dynamics

Journal of Political Economy, 2002

Macroeconomic models of nominal exchange rates perform poorly. In sample, R 2 statistics as high as 10 percent are rare. Out of sample, these models are typically out-forecast by a naïve random walk. This paper presents a model of a new kind. Instead of relying exclusively on macroeconomic determinants, the model includes a determinant from the field of microstructure-order flow. Order flow is the proximate determinant of price in all microstructure models. This is a radically different approach to exchange rate determination. It is also strikingly successful in accounting for realized rates. Our model of daily exchange-rate changes produces R 2 statistics above 50 percent. Out of sample, our model produces significantly better short-horizon forecasts than a random walk. For the DM/$ spot market as a whole, we find that $1 billion of net dollar purchases increases the DM price of a dollar by about 1 pfennig.

Market Microstructure and the Profitability of Currency Trading

Annual Review of Financial Economics, 2012

Currency trading is a vast and highly profitable business. This review examines the profitability of two popular currency trading strategies in light of currency-market microstructure research. The carry-trade strategy involves borrowing a low-interest currency and investing the proceeds in a high-interest currency. Technical trading strategies are determined exclusively on the basis of past asset prices and trading volumes. Under the efficient markets hypothesis, neither of these approaches to speculative trading should produce excess returns. The review shows that the profitability of carry-trade investing and technical trading strategies can represent rational long-run equilibria given the structure of currency markets and the incentives and constraints faced by traders.