New Micro Exchange-Rate Economics: Working Papers
Exchange Rate Fundamentals and Order Flow
Martin D.D. Evans and Richard K. Lyons
July 2004
Abstract
This paper addresses whether transaction flows in foreign exchange markets convey information about fundamentals. We begin with a GE model in the spirit of Hayek (1945) in which fundamental information is first manifest in the economy at the micro level, i.e., in a way that is not symmetrically observed by all agents. With this information structure, induced foreign exchange transactions play a central role in the aggregation process, providing testable links between transaction flows, exchange rates, and future fundamentals. We test these links using data on end-user trades at a major bank over six years, a sample sufficiently long to analyze real-time forecasts at the quarterly horizon. Four findings are both new to the literature and supportive of our model: (1) transaction flows forecast future macro variables such as output growth, money growth, and inflation, (2) transaction flows generally forecast these macro variables better than spot rates do, (3) transaction flows (proprietary) forecast future spot rates, and (4) though flows convey new information about future fundamentals, much of this information is still not impounded in the spot rate one quarter later. The significance of transaction flows for exchange rates appears to extend well beyond high frequencies.
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Meese-Rogoff Redux: Micro-Based Exchange Rate Forecasting
Martin D.D. Evans and Richard K. Lyons
Forthcoming in the American Economic Review (NBER Working Paper 11042, January 2005)
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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An Information Approach to International Currencies
Richard K. Lyons and Michael J. Moore
February 2005
Abstract
This paper addresses currency competition from an information perspective. Transactions in traditional models do not convey information, so transaction costs—the driver of competition outcomes—are driven by market size. In our model transactions do convey information (consistent with recent empirical findings). Several important departures arise. First, adding the information dimension resolves the traditional indeterminacy of currency trade patterns (by mitigating the concentrating force of market-size economies). Second, whether transactions are executed directly or through a vehicle actually affects prices (because these trading methods do not in general reveal the same information). Third, our model provides a new rationale for why some currency pairs never trade directly (information is not sufficiently symmetric to support trading). Fourth, our model formalizes the arbitrage process and shows that arbitrage transaction quantities and price levels are jointly determined. Empirically, the paper provides a first integrated analysis of transactions in a triangle of markets: ¥/$, $/€, and ¥/€. Data for the full triangle permits comparison of direct, indirect and arbitrage transactions, for each pair. The information model makes the important prediction that transactions should affect prices across markets (e.g., flow in the ¥/$ market should convey information relevant to $/€ and ¥/€ prices), which is borne out.
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A New Micro Model of Exchange Rate Dynamics
Martin D.D. Evans and Richard K. Lyons
NBER Working Paper 10379, March 2004
Abstract
We address the puzzle of exchange rate determination by examining how information is aggregated in dynamic general equilibrium (DGE). 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 resolution of the "order flow puzzle"--that transaction flows can account for monthly exchange rate changes, whereas macro variables cannot. Though micro analysis has already made progress on results (1) and (2), our results on these points arise for a qualitatively different reason: here, rational exchange rate errors feed back into, and persistently alter, the underlying real fundamentals. Calibrations show that the effects of micro-based information aggregation significantly weaken the empirical link between exchange rates and fundamentals over macro-relevant horizons.
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How Is Macro News Transmitted to Exchange Rates?
Martin D.D. Evans and Richard K. Lyons
NBER Working Paper 9433, January 2003, revised March 2006. (Former title: “Why Order Flow Explains Exchange Rates.”)
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
Forthcoming in the Journal of International Money and Finance (July 2004)
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
Forthcoming in the Journal of International Money and Finance. (Revised version of NBER Working Paper 8491, September 2001.)
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
Forthcoming in the Journal of Business. (Revised version of NBER Working Paper 9893, August 2003.)
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
August 2002
Forthcoming in Exchange Rate Economics: Where Do We Stand? Edited by Paul De Grauwe, MIT Press. (Revised version of NBER Working Paper 8356, July 2001.)
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
August 2001
Forthcoming in the Journal of International Economics. (Revised version of NBER Working Paper 7855, August 2000.)
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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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.
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