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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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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.
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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copy of the paper in Adobe's PDF format.
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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copy of the paper in Adobe's PDF format.
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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of the paper in Adobe's PDF format.
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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the paper in Adobe's PDF format.
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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copy of the paper in Adobe's PDF format.
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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copy of the paper in Adobe's PDF format.
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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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.
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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.
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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.
Contact Information
Rich Lyons
Former 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 Former Dean:
Marco Lindsey
Tel: 510-643-2027
Fax: 510-642-5630
marco@haas.berkeley.edu
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