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Order flows and the exchange rate disconnect puzzle

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  • Evans, Martin D.D.

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. The model examines how dispersed microeconomic information known to individual agents outside the foreign exchange market is aggregated and transmitted to dealers via transaction flows (i.e., order flow); and how the information is then embedded in the spot exchange rate. 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% 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.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of International Economics.

Volume (Year): 80 (2010)
Issue (Month): 1 (January)
Pages: 58-71

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Handle: RePEc:eee:inecon:v:80:y:2010:i:1:p:58-71

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Web page: http://www.elsevier.com/locate/inca/505552

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Keywords: Exchange rate dynamics The exchange rate disconnect puzzle Microstructure Order Flow;

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References

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Citations

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Cited by:
  1. Michael King & Carol Osler & Dagfinn Rime, 2012. "The Market Microstructure Approach to Foreign Exchange: Looking Back and Looking Forward," Working Papers, Brandeis University, Department of Economics and International Businesss School 54, Brandeis University, Department of Economics and International Businesss School.
  2. Nedeljković, Milan & Urošević, Branko, 2012. "Determinants of the Dinar-Euro Nominal Exchange Rate," Journal for Economic Forecasting, Institute for Economic Forecasting, Institute for Economic Forecasting, vol. 0(3), pages 121-141, September.
  3. Emanuel Kohlscheen, 2012. "Order Flow and the Real: Indirect Evidence of the Effectiveness of Sterilized Interventions," Working Papers Series, Central Bank of Brazil, Research Department 273, Central Bank of Brazil, Research Department.
  4. Andrés Felipe García-Suaza & Jose Eduardo Gómez González, . "A Simple Test of Momentum in Foreign Exchange Markets," Borradores de Economia 647, Banco de la Republica de Colombia.
  5. Kentaro Iwatsubo & Ian W. Marsh, 2011. "Order Flows, Fundamentals and Exchange Rates," Discussion Papers 1120, Graduate School of Economics, Kobe University.
  6. Menzie D. Chinn & Michael J. Moore, 2008. "Private Information and a Macro Model of Exchange Rates: Evidence from a Novel Data Set," NBER Working Papers 14175, National Bureau of Economic Research, Inc.
  7. Charles Engel, 2013. "Exchange Rates and Interest Parity," NBER Working Papers 19336, National Bureau of Economic Research, Inc.
  8. Juan José Echavarría & Luis Fernando Melo & Santiago Téllez & Mauricio Villamizar, 2013. "The impact of pre-announced day-to-day interventions on the Colombian exchange rate," BIS Working Papers 428, Bank for International Settlements.
  9. Balke, Nathan S. & Ma, Jun & Wohar, Mark E., 2013. "The contribution of economic fundamentals to movements in exchange rates," Journal of International Economics, Elsevier, Elsevier, vol. 90(1), pages 1-16.
  10. F. Pancotto & G. Pignataro & D. Raggi, 2014. "Higher order beliefs and the dynamics of exchange rates," Working Papers wp957, Dipartimento Scienze Economiche, Universita' di Bologna.

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