Order Flows
and The Exchange Rate Disconnect Puzzle
PDF File This
version: June 2008
Abstract The aim of this paper is to
establish the link between the high frequency dynamics of spot exchange rates
and developments in the macroeconomy. To do so, I first present a theoretical
model of exchange-rate determination that bridges the gap between existing
microstructure and traditional models. I then report empirical evidence that
strongly supports the presence of the link between the macroeconomy, order
flow, and high frequency exchange rate returns implied by the model. In fact,
my empirical results indicate that between 20 and 30 percent of the variance in
excess currency returns over one- and two-month horizons can be linked back to
developments in the macroeconomy. This level of explanatory power is an order
of magnitude higher than that found in traditional models -- even the newly
developed monetary models incorporating central banks reaction functions.
Moreover, it provides a straightforward solution to the exchange-rate
disconnect puzzle. Namely, the high frequency behavior of spot exchange rates reflects
the flow of new information reaching dealers concerning the slowly evolving
state of the macroeconomy, rather than the effects of shocks that drive rapidly
changing macroeconomic conditions.
International Financial Integration and The Real Economy (with V. Hnatkovska)
PDF File This
version: January 2007
Abstract What are the consequences of
financial integration for the real economy? This paper develops a set of
theoretical benchmarks for the link between integration and macroeconomic
volatility and welfare. The analysis is conducted in a standard two-sector
international real business cycle model in which we introduce dynamic portfolio
choice over equities and an international bond. The model predicts an increase
in the volatility of output in response to integration, while the relation
between integration and consumption volatility is hump-shaped. We also find
that financial integration is associated with significant improvement in
risk-sharing across countries, although in aggregate the welfare benefits are
very small. At the same time, the level of financial integration significantly
affects how the welfare benefits of productivity shocks are distributed internationally.
Foreign Exchange Market Microstructure
PDF File This
version: October 2005
Abstract This paper provides an overview of the
recent literature on Foreign Exchange Market Microstructure. Its aim is not to
survey the literature, but rather to provide an introductory tour to the main
theoretical ideas and empirical results. The central theoretical idea is that
trading is an integral part of the process through which information relevant
to the pricing of foreign currency becomes embedded in spot rates. Micro-based
models study this information aggregation process and produce a rich set of
empirical predictions that find strong support in the data. In particular,
micro-based models can account for a large proportion of the daily variation in
spot rates. They also supply a rationale for the apparent disconnect between
spot rates and fundamentals. In terms of forecasting, micro-based models
provide out-of-sample forecasting power for spot rates that is an order of
magnitude above that usually found in exchange-rate models.
International Capital Flows Returns and World Financial Integration (with V. Hnatkovska)
PDF File This version: October 2005
Abstract International capital flows have increased
dramatically since the 1980s, with much of the increase being due to trade in
equity and debt markets. Such developments are often attributed to the
increased integration of world financial markets. We present a model that allows
us to examine how greater integration in world financial markets affects the
behavior of international capital flows and financial returns. Our model
predicts that international capital flows are large (in absolute value) and
very volatile during the early stages of financial integration when
international asset trading is concentrated in bonds. As integration progresses
and households gain access to world equity markets, the size and volatility of
international bond flows fall dramatically but continue to exceed the size and
volatility of international equity flows. This is the natural outcome of
greater risk sharing facilitated by increased integration. We find that the
equilibrium flows in bonds and stocks are larger than their empirical
counterparts, and are largely driven by variations in equity risk premia. The
paper also makes a methodological contribution to the literature on dynamic
general equilibrium asset-pricing. We implement a new technique for solving a
dynamic general equilibrium model with production, portfolio choice and
incomplete markets.
Solving General Equilibrium Models with Incomplete Markets and Many Assets (with V. Hnatkovska)
PDF File This version: October 2005
Abstract This paper presents a new numerical method
for solving general equilibrium models with many assets. The method can be
applied to models where there are heterogeneous agents, time-varying investment
opportunity sets, and incomplete markets. It also can be used to study models
where the equilibrium dynamics are non-stationary. We illustrate how the method
is used by solving a one— and two-sector versions of a two—country general
equilibrium model with production. We check the accuracy of our method by
comparing the numerical solution to the one-sector model against its known
analytic properties. We then apply the method to the two-sector model where no analytic solution is available.
Exchange Rate Fundamentals and Order Flow (With Richard Lyons)
PDF File This version: May 2005
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 all end-user currency trades
received by Citibank over 6.5 years, a sample sufficiently long to analyze
real-time forecasts at the quarterly horizon. The predictions are borne out in
four empirical findings that define this paper’s main contribution: (1)
transaction flows forecast future macro variables such as output growth, money
growth, and inflation, (2) transaction flows forecast these macro variables
significantly better than spot rates do, (3) transaction flows (proprietary)
forecast future spot rates, and (4) though proprietary flows convey new
information about future fundamentals, much of this information is still not
impounded in the spot rate one quarter later. These results indicate that the
significance of transaction flows for exchange rates extends well beyond high
frequencies.
A New Micro Model of Exchange Rate Dynamics (With Richard Lyons)
PDF File This version: January 2005
Abstract We address the puzzle of what determines exchange rates by examining information aggregation 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 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 fundamentals, (2) excess volatility relative to fundamentals, (3) exchange rate movements without macro news, (4) little or no exchange rate movement when macro news occurs, and (5) a structural rationale for why transaction flows perform well in accounting for monthly exchange rate changes, whereas macro variables perform poorly.
How is Macro News Transmitted to Exchange Rates? (With Richard Lyons)
PDF File This version December 2003. Original Version ("Why Order Flow Explains Exchange Rates")
Abstract This paper tests whether macroeconomic news is transmitted to exchange rates via the transactions process and if so, what share occurs via transactions versus the traditional direct channel. We identify the link between order flow and macro news using a heteroskedasticity-based approach, a la Rigobon and Sack (2002). In both daily and intra-daily data, order flow varies considerably with macro news flow. At least half of the effect of macro news on exchange rates is transmitted via order flow.
What are the Origins of Foreign Exchange Movements?
Abstract: This paper uses a new transactions data set on the inter bank foreign exchange market to examine the origins of spot exchange rate movements. The data provide a comprehensive picture of trading activity and allow me to examine the contribution of public news to spot rate dynamics over hours, days, and weeks. Contrary the presumption of macroeconomic exchange rates models, I find that public news only accounts for a fraction of exchange rate volatility over the whole frequency spectrum. In particular, I estimate that less that 50\% of the variance of spot rate changes at very high frequencies is attributable to public news. At daily and weekly frequencies, changes in the spot rate understate the effects of public news by 20 to 40 percent because the cumulative effects of independent public and private news exert offsetting effects. These findings suggest one reason for the poor performance of macroeconomic exchange rate models; namely their exclusive focus on public news.
The Microstructure of Foreign Exchange Dynamics
Abstract: This paper studies the high frequency behavior of the interbank foreign exchange market with a newly created data set that provides the most comprehensive picture of activity across the market in existence. My analysis indicates that trade activity within the interbank market is distinct from the posting of indicative quotes. Trading and quote-making decisions are linked, but the links are complicated and poorly understood. I also document the existence of strong relationship between exchange rate movements and a measure of excess Dollar demand. A trading model is analyzed to show how the structure of the market could give rise to such a microstructure effect. Empirically, this effect appears important in the determination of exchange rates at high frequencies and over longer time spans relevant in international macroeconomics.
Inventory Information (The Journal of Business, 2006)
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 immediate price impact of shocks to
inventory information is large, roughly 50 percent of that from public
information shocks (the latter being the whole story under symmetric
information). Within about 30 minutes the transitory effect dies out, and
prices reflect a permanent effect from inventory information that ranges
between 15 and 30 percent of that from public information.
Understanding Order Flow (The International Journal of Finance and Economics, 2005)
Abstract This paper develops a model for
understanding end-user order flow in the FX market. The model addresses several
puzzling findings. First, the estimated price--impact of flow from different
end--user segments is, dollar--for--dollar, quite different. Second, order flow
from segments traditionally thought to be liquidity--motivated actually has
power to forecast exchange rates. Third, about one third of order flow's power
to forecast exchange rates one month ahead comes from flow's ability to
forecast future flow, whereas the remaining two--thirds applies to price
components unrelated to future flow. We show that all of these features arise
naturally from end--user heterogeneity, in a setting where order flow provides
timely information to market--makers about the state of the macroeconomy.
Meese-Rogoff Redux: Micro-Based Exchange Rate Forecasting (American Economic Review, Papers and Proceedings, May 2005)
Abstract This paper compares the true, ex-ante forecasting performance of a micro-based model against both a standard macro model and a random walk. In contrast to existing literature, which is focused on longer horizon forecasting, we examine forecasting over horizons from one day to one month (the one-month horizon being where micro and macro analysis begin to overlap). Over our 3-year forecasting sample, we find that the micro-based model consistently out-performs both the random walk and the macro model. Micro-based forecasts account for almost 16 per cent of the sample variance in monthly spot rate changes. These 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.
Where Are We Now? Real-time Estimates of the Macro Economy, (The International Journal of Central Banking, 2005)
Abstract This paper describes a method for
calculating daily real-time estimates of the current state of the
Are Different-Currency Assets Imperfect Substitutes (Forthcoming, in Exchange Rate Economics, MIT Press)
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 $1 billion (of which, about 80 percent persists indefinitely). This estimate is applicable to intervention trades in the special case when they are indistinguishable from private trades (i.e., when interventions are sterilized, anonymous, and provide no monetary-policy signal).
PDF File (With Richard Lyons) Revised version of NBER Working Paper 8356, July 2001.)
Do Currency Markets Absorb News Quickly? (Journal of International Money and Finance March 2005)
Abstract This paper addresses whether macro news arrivals affect currency markets over time. The null from macro exchange-rate theory is that they do not: macro news is impounded in exchange rates instantaneously. We test this by examining the effects of news on subsequent trades by end-user participants (such as hedge funds, mutual funds, and non-financial corporations). News arrivals induce subsequent changes in trading in all of the major end-user segments. These induced changes remain significant for days. Induced trades also have persistent effects on prices. Currency markets are not responding to news instantaneously.
PDF File (With Richard Lyons)
Time-Varying Liquidity in Foreign Exchange (Journal of Monetary Economics 2002)
Abstract This paper addresses whether currency trades have greater price impact during periods of rapid public information flow. Central bankers often suggest that expectations are at times “ripe” for coordinated adjustment, and that periods of rapid information flow are such a time. We develop an optimizing model to account for the joint behavior of order flow and returns around announcements. Using transaction data made available by electronic trading, we estimate the price impact of trades in the DM/$ market precisely. We then test whether trades during periods with macroeconomic announcements have higher price impact. They do. We also test for dependence of liquidity on trading volume and return volatility (two other prominent state variables in the literature on liquidity variation). We do not find any evidence that liquidity depends on these variables. The findings provide policy-makers with guidance for the timing and magnitude intervention.
PDF File (With Richard Lyons)
FX Trading and Exchange Rate Dynamics (Journal of Finance 2002)
Abstract: This paper provides new perspective on the poor performance of exchange rate models by focusing on the information structure of FX trading. I present a new theoretical model of FX trading that emphasizes the role of incomplete and heterogeneous information. The model shows how an equilibrium distribution of FX transaction prices and orders can arise at each point in time from the optimal trading decisions of dealers. This result motivates an empirical investigation of how the equilibrium distribution of FX prices behaves using a new data set that details trading activity in the FX market. This analysis produces two striking results: (i) Much of the observed short-term volatility in exchange rates comes from sampling the heterogeneous trading decisions of dealers in an equilibrium distribution that, under normal market conditions, changes comparatively slowly. (ii) In contrast to the assumptions of traditional macro models, public news is rarely the predominant source of exchange rate movements over any horizon.
Last version PDF File, NBER WP version PDF File
Real Risk, Inflation Risk and the Term Structure
Abstract: I develop and estimate a general
equilibrium model for the term structures of nominal and real interest rates in
the
Abstract:
In this paper we consider models of the term structure of default risk and
apply them to a sample of risky Brady bonds issued by the governments of
Abstract This paper is an assessment of the limits
of using data from student evaluations for the evaluation of teaching
performance or “effectiveness” in undergraduate classes at
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