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Fixed versus flexible: Lessons from EMS order flow

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  • Killeen, William P.
  • Lyons, Richard K.
  • Moore, Michael J.

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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Article provided by Elsevier in its journal Journal of International Money and Finance.

Volume (Year): 25 (2006)
Issue (Month): 4 (June)
Pages: 551-579

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Handle: RePEc:eee:jimfin:v:25:y:2006:i:4:p:551-579

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Web page: http://www.elsevier.com/locate/inca/30443

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