Rich Lyons

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Published work by Rich Lyons in New Micro exchange-rate economics

Order Flow and Exchange Rate Dynamics

Martin D.D. Evans and Richard K. Lyons
Journal of Political Economy, February 2002, 170-180.

Abstract
This paper presents an exchange rate model of a new kind. Instead of relying exclusively on macroeconomic determinants, the model includes a determinant from the field of microstructure finance--order flow. Order flow is a determinant because it conveys information. This is a radically different approach to exchange rates. It is also strikingly successful. Our model of daily deutsche mark/dollar log changes produces an R2 statistic above 60 percent. For the deutsche mark/dollar spot market as a whole, we find that $1 billion of net dollar purchases increases the deutsche mark price of a dollar by 0.5 percent.

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The Microstructure Approach to Exchange Rates

Richard K. Lyons
Book published by MIT Press, December 2001, 333 pages.

Abstract
Historically, the fields of exchange-rate economics and microstructure finance have progressed independently. Recent interaction, however, has given rise to a microstructure approach to exchange rates. This book focuses on the economics of financial information and how microstructure tools help to clarify the types of information most relevant to exchange rates. The microstructure approach views exchange rates from the perspective of the trading room, the place where exchange rates are actually determined. Emphasizing information economics over institutional issues, the approach departs from three unrealistic assumptions common to previous approaches: that all information relevant to exchange rates is publicly available, that all market participants are alike in their goals or in how they view information, and that how trading is organized is inconsequential for exchange rates. The book shows how exchange-rate behavior previously thought to be puzzling can be explained using the microstructure approach. It contains a combination of theoretical and empirical work.


Meese-Rogoff Redux: Micro-Based Exchange Rate Forecasting

Martin D.D. Evans and Richard K. Lyons
American Economic Review, 2005, 95: 405-414.

Abstract
This paper compares true, ex-ante forecasting performance of a micro-based model against both a standard macro model and a random walk. Our forecast horizons extend up to one month (the one-month horizon being where micro and macro analysis begin to overlap). Over our 5-year forecasting sample, the micro-based model consistently out-performs both the random walk and the macro model. Because our analysis is not based on concurrent, realized values of the forcing variables--as was that of Meese and Rogoff (1983)--the results provide a level of empirical validation as yet unattained by other models. Though our micro-based model out-performs the macro model, this does not imply that past macro analysis has overlooked key fundamentals: our structural interpretation using a fundamentals-based model shows that our findings are consistent with exchange rates being driven by standard fundamentals.

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How Is Macro News Transmitted to Exchange Rates?

Martin D.D. Evans and Richard K. Lyons
Journal of Financial Economics, 2008, 88: 26-50.

Abstract
This paper tests whether macroeconomic news is transmitted to exchange rates via induced transactions, and if so, what share occurs via transactions versus traditional direct adjustment of price. We identify the link between order flow and macro news using a heteroskedasticity-based approach. This involves jointly testing (1) whether macro news flow increases order flow volatility and (2) whether the induced order flow has signed (first moment) effects on the exchange rate. The answer to both questions is yes: in both daily and intra-daily data, order flow is considerably more volatile when macro news is flowing, and these signed orders have the theoretically predicted effects on the exchange rate’s direction. Of news’ total price effect, induced order flow accounts for two-thirds, with direct news effects accounting for one-third. In terms of total exchange rate variation, the order flow channel brings news’ explanatory power up to 30 percent, versus estimates in the 1–5 percent range from existing literature, helping to resolve the puzzle of missing news effects.

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Do Currency Markets Absorb News Quickly?

Martin D.D. Evans and Richard K. Lyons
Journal of International Money and Finance, 2005, 24: 197-217.

Abstract
This paper addresses whether macro news arrivals affect currency markets over time. The null from macro exchange-rate theory is that they do not: macro news is impounded in exchange rates instantaneously. We test this by examining the effects of news on subsequent trades by end-user participants (such as hedge funds, mutual funds, and non-financial corporations). News arrivals induce subsequent changes in trading in all of the major end-user segments. These induced changes remain significant for days. Induced trades also have persistent effects on prices. Currency markets are not responding to news instantaneously.

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Fixed versus Flexible: Lessons from EMS Order Flow

William P. Killeen, Richard K. Lyons, and Michael J. Moore
Journal of International Money and Finance, 2006, 25: 551-579.

Abstract
This paper addresses the puzzle of regime-dependent volatility in foreign exchange. We extend the literature in two ways. First, our microstructural model provides a qualitatively new explanation for the puzzle. Second, we test implications of our model using Europe's recent shift to rigidly fixed rates (EMS to EMU). In the model, shocks to order flow induce volatility under flexible rates because they have portfolio-balance effects on price, whereas under fixed rates the same shocks do not have portfolio-balance effects. These effects arise in one regime and not the other because the elasticity of speculative demand for foreign exchange is (endogenously) regime-dependent: low elasticity under flexible rates magnifies portfolio-balance effects; under credibly fixed rates, elasticity of speculative demand is infinite, eliminating portfolio-balance effects. New data on FF/DM transactions show that order flow had persistent effects on the exchange rate before EMU parities were announced. After announcement, determination of the FF/DM rate was decoupled from order flow, as predicted by the model.

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Inventory Information

H. Henry Cao, Martin D.D. Evans, and Richard K. Lyons
Journal of Business, 2006, 79: 325-364.

Abstract
In a market with symmetric information about fundamentals, can information-based trade still arise? Consider bond and FX markets, where private information about nominal cash flows is generally absent, but participants are convinced that superior information exists. We analyze a class of asymmetric information—inventory information—that is unrelated to fundamentals, but still forecasts future price (by forecasting future discount factors). Empirical work based on the analysis shows that inventory information in FX does indeed forecast discount factors, and does so over both short and long horizons. The price impact of inventory information is large, roughly 50 percent of that from public information (the latter being the whole story under symmetric information). Within 30 minutes, the transitory effect dies out, and prices reflect a permanent effect from inventory information between 15 and 30 percent of that from public information.

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Are Different-Currency Assets Imperfect Substitutes?

Martin D.D. Evans and Richard K. Lyons
In Exchange Rate Economics: Where Do We Stand? Edited by Paul de Grauwe, MIT Press, 2005.

Abstract
This paper provides a new test for whether different-currency assets are imperfect substitutes. Past work on imperfect substitutability in foreign exchange falls into two groups: (1) tests using measures of asset supply and (2) tests using measures of central-bank asset demand. We address the demand side, but we use a broad measure of public demand rather than focusing on demand by central banks. Under floating rates, changing public demand has no direct effect on monetary fundamentals, current or future. This provides an opportunity to test for price effects from imperfect substitutability. We develop and estimate a micro portfolio balance model that has both Walrasian and microstructure features. Price effects from imperfect substitutability are clearly present: the immediate price impact of public trades is 0.44 percent per $1 billion (of which, about 80 percent persists indefinitely). This estimate is applicable to intervention trades in the special case when they are indistinguishable from private trades (i.e., when interventions are sterilized, anonymous, and provide no monetary-policy signal).

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Managers, Investors, and Crises: Mutual Fund Strategies in Emerging Markets

Graciela Kaminsky, Richard K. Lyons, and Sergio Schmukler
Journal of International Economics., 2004, 64: 113-134.

Abstract
This paper examines the trading strategies of mutual funds in emerging markets. The data set we construct permits analysis of these strategies at the level of individual portfolios. Methodologically, a novel feature is our disentangling the behavior of managers from that of underlying investors. For both managers and investors, we strongly reject the null hypothesis of no momentum trading: funds' momentum trading is positive--they systematically buy winners and sell losers. Contemporaneous momentum trading (buying current winners and selling current losers) is stronger during crises, and stronger for fund investors than for fund managers. Lagged momentum trading (buying past winners and selling past losers) is stronger during non-crisis, and stronger for fund managers. Investors also engage in contagion trading, i.e., they sell assets from one country when asset prices fall in another.

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Time-Varying Liquidity in Foreign Exchange

Martin D.D. Evans and Richard K. Lyons
Journal of Monetary Economics, 2002, 49(5): 1025-1051.

Abstract
This paper addresses whether currency trades have greater price impact when public information is flowing rapidly. We develop an optimizing model to account for why public news should increase the price impact of trades. Using transaction data made available by electronic trading, we estimate the price impact of DM/$ trades precisely and then test whether trades following macroeconomic announcements have higher price impact. They do: price impact per dollar traded is about 10 percent higher per announcement in the previous hour (the sample maximum number of announcements in an hour is six). The findings provide policy-makers with guidance for the timing and magnitude intervention.


Informational Integration and FX Trading

Martin D.D. Evans and Richard K. Lyons
Journal of International Money and Finance, November 2002, 21(6): 807-831.

Abstract
This paper addresses international financial integration in a new way. We focus on informational integration, specifically, the importance of information conveyed by order flow in major currencies for pricing minor currencies. We develop a multi-currency model of portfolio allocation in the presence of dispersed information. We then test the model’s implications using four months of concurrent transaction data on nine currencies. The model explains 45 to 78 percent of daily returns in all nine currencies. Moreover, its prediction that order flow in individual markets should be relevant for determining prices in other markets is borne out.


Customer Trades and Extreme Events in Foreign Exchange

Mintao Fan and Richard K. Lyons

Published in Monetary History, Exchange Rates and Financial Markets: Essays in Honour of Charles Goodhart, Paul Mizen (ed.), Edward Elgar: Northampton, MA, USA, 2003, pages 160-179.

Abstract
This paper is an introduction to the trading of FX customers. Understanding the demands of customers—the investors, importers, exporters, corporate Treasurers, etc.—is an important frontier for work on how exchange rates impound dispersed information. In section one, we provide background on available customer-trade data. Section two introduces hypotheses from recent models of FX customer trading and puts them to the test. Section three presents a case study on the roughly 10 percent drop in the yen/$ rate that occurred in October 1998 in a single day (around the time of the LTCM collapse). We find that hedge funds were not the trigger of the collapse, but instead were net providers of liquidity (i.e., net buyers of dollars). The trigger was the portfolio shift of the unleveraged financial institutions (e.g., mutual funds, pension funds, etc.). The paper concludes by examining other extreme movements in the dollar-yen and dollar-euro markets. High frequency extreme events are generally associated with large net flows from financial institutions. Low frequency trends are associated with secular net flows from non-financial corporations.

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Foreign Exchange: Macro Puzzles, Micro Tools

Richard K. Lyons
2002

Economic Review 2002, Federal Reserve Bank of San Francisco, 51-69.

Abstract
This paper reviews recent progress in applying information-theoretic tools to long-standing exchange rate puzzles. I begin by distinguishing the traditional public information approach (e.g., monetary models, including new open-economy models) from the newer dispersed information approach. (The latter focuses on how information is aggregated in the trading process.) I then review empirical results from the dispersed information approach and relate them to two key puzzles, the determination puzzle and the excess volatility puzzle. The dispersed information approach has made progress on both.

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The Failure of Empirical Exchange Rate Models: Room for Optimism?

Richard K. Lyons
May 2002

Economic Policy (Web Essay).

Abstract
This paper addresses whether the Meese-Rogoff puzzle has been resolved. There is a sense in which it hasn’t and there is a sense in which it has. There are two versions of the puzzle: (1) Macro variables cannot account for exchange rates empirically and (2) No well-specified model can account for exchange rates empirically. The first version of the puzzle does indeed remain unresolved. The second, broader version of the puzzle continues to trouble many people who are not specialists in this area – yet this version of the puzzle has been recently resolved. The resolution is embedded in recent success using micro-empirical approaches based on earlier theoretical insights on the information economics of trading (e.g., work by Pete Kyle, Larry Glosten, and Paul Milgrom). Resolution of the broader, second version of the puzzle can help us to understand why macro variables alone can’t do the job.


Forex Markets and the Euro: Theoretical Perspective

Richard K. Lyons
October 2002

Economic Policy, October 2002, 35: 573-597.

Abstract
I provide theoretical perspective on recent findings of increased transaction costs in the new dollar-euro market relative to the prior dollar-mark market, and assess the welfare significance of this drop in liquidity. In theory, transaction costs arise from information disadvantage costs, inventory management costs, and other marketmaking costs (e.g., order-processing costs). A review of the theoretical reasons for the underlying costs to be rising can allow one to discriminate among hypotheses for the liquidity drop. New data on public trades support a customer liquidity hypothesis, based on the idea the ultimate providers of liquidity in this market are customers rather than market-makers. However, the hypothesis is not consistent with the totality of the evidence, and I discuss how a combination of various mechanisms can influence transaction costs and the FX market’s information efficiency.


The Future of the Foreign Exchange Market

Richard K. Lyons
March 2002

Brookings-Wharton Papers on Financial Services, Robert Litan and Richard Herring (eds.), Brookings Institution Press: Washington, DC, 253-280.

Abstract
This paper addresses the future of the foreign exchange market using two organizing (and provocative) ideas. One pertains to the market’s institutional structure, the other to its information structure. The first organizing idea is that the structure of currency markets is driven primarily by the management of credit risk. This contrasts with drivers identified by microstructure theory (such as management of market risk, attenuation of asymmetric information, and entry barriers). The second organizing idea is that price variation in spot currency markets is driven primarily by dispersed information. This too contrasts with the orthodox view, under which exchange rates are determined from public information. Though provocative, these two ideas are vital to understanding this market’s future. Based on drivers of the market’s current structure, I propose three scenarios for future evolution. The scenario I consider most likely is one in which the current dealer structure is maintained through dealing banks’ cross-subsidizing their liquidity provision using gains from superior order flow information.

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New Perspective on FX Markets: Order-Flow Analysis

Richard K. Lyons
International Finance, Summer 2001, 303-320.

Abstract
Though fundamental and technical analysis are still widely used in foreign exchange markets, a new type of analysis has emerged: order-flow analysis. Order-flow analysis uses the flow of buy and sell orders to both explain exchange rates contemporaneously and forecast future movements. This article contrasts order-flow analysis with the traditional approaches and reviews lessons learned. Most important among those lessons is order flow's ability to account for the lion's share of movements in the major floating rates. On the policy front, widespread availability of electronic order-flow data brings many policy questions within reach for the first time. After reviewing these policy questions, the article closes with a discussion of how FX market institutions are evolving and how this evolution will affect application of order-flow analysis in the future.


Is There Private Information in the FX Market? The Tokyo Experiment

Takatoshi Ito, Richard K. Lyons, and Michael T. Melvin
Journal of Finance, June 1998, 1111-1130.

Abstract
It is a common view that private information in the foreign exchange market does not exist. We provide evidence against this view. The evidence comes from the introduction of trading in Tokyo over the lunch-hour. Lunch return variance doubles with the introduction of trading, which cannot be due to public information since the flow of public information did not change with the trading rules. Having eliminated public information as the cause, we exploit recent results in microstructure to discriminate between the two alternatives: private information and pricing errors. Three key results support the predictions of private-information models. First, the volatility U-shape flattens: greater revelation over lunch leaves a smaller share for the morning and afternoon. Second, the U-shape tilts upward, an implication of information whose private value is transitory. Finally, the morning exhibits a clear U-shape when Tokyo closes over lunch, and it disappears when trading is introduced.


Profits and Position Control: A Week of FX Dealing

Richard K. Lyons
Journal of International Money and Finance, February 1998, 97-115.

Abstract
This paper examines foreign exchange trading at the dealer level. The dealer we track averages $100,000 in profits per day on volume of $1 billion per day. The half-life of the dealer's position is only ten minutes, providing strong support for inventory models. A methodological innovation allows us to identify his speculative position over time. This speculative position determines the share of profits deriving from speculation versus intermediation: intermediation is much more important.


A Simultaneous Trade Model of the Foreign Exchange Hot Potato

Richard K. Lyons
Journal of International Economics, May 1997, 275-298.

Abstract
This paper develops a simultaneous trade model of the spot foreign exchange market (cf., the sequential trade approach to dealing). The model produces hot-potato trading — a term that refers to the repeated passing of inventory imbalances between dealers. At the outset, risk-averse dealers receive customer orders that are not generally observable. Dealers then trade among themselves. Thus, each dealer intermediates both his customers' trades and any information contained therein. This information is subsequently revealed in price depending on the information in interdealer trades. We show that hot-potato trading reduces the information in interdealer trades, making price less informative.


Optimal Transparency in a Dealer Market with an Application to Foreign Exchange

Richard K. Lyons
Journal of Financial Intermediation, July 1996, 225-254.

Abstract
This paper addresses a fundamental trade-off in the design of multiple-dealer markets. Namely, though greater transparency can accelerate revelation of information in price, it can also impede dealer risk management. If dealers could choose the transparency regime ex ante, which regime would they choose? We show that dealers prefer incomplete transparency (meaning marketwide order flow is observed with noise). Slower price adjustment provides time for nondealers to trade, thereby sharing risk otherwise borne by dealers. At some point, however, further reduction in transparency impedes risk sharing: too noisy a public signal provides nondealers too little information to induce them to trade.


Foreign Exchange Volume: Sound and Fury Signifying Nothing?

Richard K. Lyons
in The Microstructure of Foreign Exchange Markets, J. Frankel et al. (eds.), University of Chicago Press, 1996, 183-201.

Abstract
This paper examines whether currency trading volume is informative, and under what circumstances. Specifically, we use transactions data to test whether trades occurring when trading intensity is high are more informative — dollar for dollar — than trades occurring when intensity is low. Theory admits both possibilities, depending primarily on the posited information structure. We present what we call a hot-potato model of currency trading, which explains why low-intensity trades might be more informative. In the model, the wave of inventory-management trading among dealers following innovations in order flow generates an inverse relationship between intensity and information content. In the data, low-intensity trades are more informative, supporting the hot-potato hypothesis.


Explaining Forward Exchange Bias ... Intraday

Richard K. Lyons and Andrew K. Rose
Journal of Finance, September 1995, 1321-1329.

Abstract
Intraday interest rates are zero. Consequently, a foreign exchange dealer can short a vulnerable currency in the morning, close this position in the afternoon, and never face an interest cost. This tactic might seem especially attractive in times of fixed-rate crisis, since it suggests an immunity to the central bank's interest rate defense. In equilibrium, however, buyers of the vulnerable currency must be compensated on average with an intraday capital gain as long as no devaluation occurs. That is, currencies under attack should typically appreciate intraday. Using data on intraday exchange rate changes within the European Monetary System, we find this prediction is borne out.


Tests of Microstructural Hypotheses in the Foreign Exchange Market

Richard K. Lyons
Journal of Financial Economics, October 1995, 321-351.

Abstract
Data in this paper support both the inventory-control and asymmetric-information approaches to microstructure theory. Strong evidence of an inventory-control effect on price is new. The transactions dataset chronicles a trading week of a spot foreign exchange dealer whose daily volume averages over $1 billion. In addition to controlling inventory with his own price, the dealer also lays off inventory at other dealers' prices and through brokers. These results highlight the importance of inventory-control theory in understanding trading in this market.


Contact Information

Rich Lyons
Dean, Haas School of Business
UC Berkeley
Berkeley, CA 94720-1900
Tel: 510-643-2027
Fax: 510-642-5630
lyons@haas.berkeley.edu

Assistant to the Dean:
Marco Lindsey
Tel: 510-643-2027
Fax: 510-642-5630
marco@haas.berkeley.edu

 

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Rich Lyons

Rich Lyons
Bank of America Dean
Haas School of Business

 

 

 

 

 

 

 

 

 

 

 

 

 

 
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