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Order flows and the exchange rate disconnect puzzle

  • Evans, Martin D.D.

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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File URL: http://www.sciencedirect.com/science/article/pii/S0022-1996(09)00065-8
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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
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505552

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  1. Martin D. D. Evans & Richard K. Lyons, 2005. "Understanding Order Flow," NBER Working Papers 11748, National Bureau of Economic Research, Inc.
  2. Evans, Martin D. D. & Lyons, Richard K., 2002. "Informational integration and FX trading," Journal of International Money and Finance, Elsevier, vol. 21(6), pages 807-831, November.
  3. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
  4. Martin D. D. Evans & Richard K. Lyons, 2003. "How is Macro News Transmitted to Exchange Rates?," NBER Working Papers 9433, National Bureau of Economic Research, Inc.
  5. Lyons, Richard K., 1997. "A simultaneous trade model of the foreign exchange hot potato," Journal of International Economics, Elsevier, vol. 42(3-4), pages 275-298, May.
  6. Philippe Bacchetta & Eric Van Wincoop, 2006. "Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?," American Economic Review, American Economic Association, vol. 96(3), pages 552-576, June.
  7. Charles Engel & Kenneth D. West, 2005. "Exchange Rates and Fundamentals," Journal of Political Economy, University of Chicago Press, vol. 113(3), pages 485-517, June.
  8. Martin D. D. Evans and Richard K. Lyons., 1999. "Order Flow and Exchange Rate Dynamics," Research Program in Finance Working Papers RPF-288, University of California at Berkeley.
  9. Evans, Martin D, 2005. "Where Are We Now? Real-Time Estimates of the Macroeconomy," MPRA Paper 831, University Library of Munich, Germany.
  10. Maurice Obstfeld & Kenneth Rogoff & Ben Bernanke & Kenneth Rogoff, . "The Six Major Puzzles in International Macroeconomics: Is there a Common Cause?," Working Paper 32326, Harvard University OpenScholar.
  11. Martin D D Evans & Viktoria V Hnatkovska, 2007. "International Financial Integration and the Real Economy," IMF Staff Papers, Palgrave Macmillan, vol. 54(2), pages 220-269, June.
  12. Berger, David W. & Chaboud, Alain P. & Chernenko, Sergey V. & Howorka, Edward & Wright, Jonathan H., 2008. "Order flow and exchange rate dynamics in electronic brokerage system data," Journal of International Economics, Elsevier, vol. 75(1), pages 93-109, May.
  13. Newey, W.K. & West, K.D., 1992. "Automatic Lag Selection in Covariance Matrix Estimation," Working papers 9220, Wisconsin Madison - Social Systems.
  14. Richard Payne, 2003. "Macroeconomic news, order flows and exchange rates," FMG Discussion Papers dp475, Financial Markets Group.
  15. Kathryn Dominguez & Freyan Panthaki, 2005. "What Defines "News" in Foreign Exchange Markets?," NBER Working Papers 11769, National Bureau of Economic Research, Inc.
  16. Mitchel Y. Abolafia (ed.), 2005. "Markets," Books, Edward Elgar Publishing, number 2788, April.
  17. Newey, Whitney K & West, Kenneth D, 1987. "A Simple, Positive Semi-definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix," Econometrica, Econometric Society, vol. 55(3), pages 703-08, May.
  18. Engel, Charles & West, Kenneth D., 2006. "Taylor Rules and the Deutschmark: Dollar Real Exchange Rate," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(5), pages 1175-1194, August.
  19. Martin D.D. Evans & Richard K. Lyons, 2004. "A New Micro Model of Exchange Rate Dynamics," NBER Working Papers 10379, National Bureau of Economic Research, Inc.
  20. Kenneth A. Froot & Tarun Ramadorai, 2005. "Currency Returns, Intrinsic Value, and Institutional-Investor Flows," Journal of Finance, American Finance Association, vol. 60(3), pages 1535-1566, 06.
  21. Evans, Martin D.D. & Lyons, Richard K., 2005. "Do currency markets absorb news quickly?," Journal of International Money and Finance, Elsevier, vol. 24(2), pages 197-217, March.
  22. Nelson C. Mark, 2009. "Changing Monetary Policy Rules, Learning, and Real Exchange Rate Dynamics," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(6), pages 1047-1070, 09.
  23. Philippe BACCHETTA & Eric VAN WINCOOP, 2004. "Higher Order Expectations in Asset Pricing," FAME Research Paper Series rp110, International Center for Financial Asset Management and Engineering.
  24. Charles Engel & Nelson C. Mark & Kenneth D. West, 2008. "Exchange Rate Models Are Not As Bad As You Think," NBER Chapters, in: NBER Macroeconomics Annual 2007, Volume 22, pages 381-441 National Bureau of Economic Research, Inc.
  25. Michael Sager & Mark P. Taylor, 2008. "Commercially Available Order Flow Data and Exchange Rate Movements: "Caveat Emptor"," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(4), pages 583-625, 06.
  26. Clarida, Richard & Gali, Jordi & Gertler, Mark, 1997. "Monetary Policy Rules in Practice: Some International Evidence," Working Papers 97-32, C.V. Starr Center for Applied Economics, New York University.
  27. Martin D. D. Evans & Richard K. Lyons, 2007. "Exchange Rate Fundamentals and Order Flow," NBER Working Papers 13151, National Bureau of Economic Research, Inc.
  28. Rime, Dagfinn & Sarno, Lucio & Sojli, Elvira, 2010. "Exchange rate forecasting, order flow and macroeconomic information," Journal of International Economics, Elsevier, vol. 80(1), pages 72-88, January.
  29. Richard K. Lyons, 1993. "Tests of Microstructural Hypotheses in the Foreign Exchange Market," NBER Working Papers 4471, National Bureau of Economic Research, Inc.
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