New Micro Exchange-Rate Economics:
Published Works
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 $1 billion of net dollar purchases increases the deutsche mark price of a dollar by 0.5 percent.
Click here for a copy of the paper in Adobe's PDF format.
The Microstructure Approach to Exchange Rates
Richard K. Lyons
Book published by MIT Press, December 2001, 333 pages.
Abstract
Historically, the fields of exchange-rate economics and microstructure finance have progressed independently. Recent interaction, however, has given rise to a microstructure approach to exchange rates. This book focuses on the economics of financial information and how microstructure tools help to clarify the types of information most relevant to exchange rates. The microstructure approach views exchange rates from the perspective of the trading room, the place where exchange rates are actually determined. Emphasizing information economics over institutional issues, the approach departs from three unrealistic assumptions common to previous approaches: that all information relevant to exchange rates is publicly available, that all market participants are alike in their goals or in how they view information, and that how trading is organized is inconsequential for exchange rates. The book shows how exchange-rate behavior previously thought to be puzzling can be explained using the microstructure approach. It contains a combination of theoretical and empirical work.
Time-Varying Liquidity in Foreign Exchange
Martin D.D. Evans and Richard K. Lyons
Journal of Monetary Economics, 2002, 49(5): 1025-1051.
Abstract
This paper addresses whether currency trades have greater price impact when public information is flowing rapidly. We develop an optimizing model to account for why public news should increase the price impact of trades. Using transaction data made available by electronic trading, we estimate the price impact of DM/$ 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.
Click here for a copy of the paper in Adobe's PDF format.
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.
Click here for a copy of the paper in Adobe's PDF format.
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.
Click here for a copy of the paper in Adobe's PDF format.
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.
[Back to top]
Correspondence
Professor Richard K. Lyons
Haas School of Business
U.C. Berkeley
Berkeley, CA 94720-1900
Tel: 510-642-1059, Fax: 510-642-4700
lyons@haas.berkeley.edu |
