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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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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. 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.
  2. Philippe Bacchetta & Eric Van Wincoop, 2008. "Higher Order Expectations in Asset Pricing," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(5), pages 837-866, 08.
  3. Martin D. D. Evans (Georgetown University), 2005. "Understanding Order Flow," Working Papers gueconwpa~05-05-19, Georgetown University, Department of Economics.
  4. Martin D.D. Evans & Richard K. Lyons, 1999. "Order Flow and Exchange Rate Dynamics," NBER Working Papers 7317, National Bureau of Economic Research, Inc.
  5. Richard K. Lyons., 1993. "Tests of Microstructural Hypotheses in the Foreign Exchange Market," Research Program in Finance Working Papers RPF-230, University of California at Berkeley.
  6. 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.
  7. Martin D.D. Evans & Richard K. Lyons, 2005. "Do Currency Markets Absorb News Quickly?," NBER Working Papers 11041, National Bureau of Economic Research, Inc.
  8. Mitchel Y. Abolafia (ed.), 2005. "Markets," Books, Edward Elgar, number 2788.
  9. Richard Clarida & Jordi Gali & Mark Gertler, 1997. "Monetary Policy Rules in Practice: Some International Evidence," NBER Working Papers 6254, National Bureau of Economic Research, Inc.
  10. Charles Engel & Kenneth D. West, 2003. "Exchange rates and fundamentals," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  11. Nelson C. Mark, 2005. "Changing Monetary Policy Rules, Learning, and Real Exchange Rate Dynamics," NBER Working Papers 11061, National Bureau of Economic Research, Inc.
  12. repec:att:wimass:9220 is not listed on IDEAS
  13. Evans, Martin D, 2005. "Where Are We Now? Real-Time Estimates of the Macroeconomy," MPRA Paper 831, University Library of Munich, Germany.
  14. 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.
  15. Maurice Obstfeld & Kenneth Rogoff, 2001. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," International Trade 0012003, EconWPA.
  16. Rich Lyons & Martin Evans, 2004. "A New Micro Model of Exchange Rate Dynamics," Econometric Society 2004 North American Winter Meetings 622, Econometric Society.
  17. Martin Evans and Richard K. Lyons, 2002. "Informational Integration and FX Trading," Working Papers gueconwpa~02-02-11, Georgetown University, Department of Economics.
  18. 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.
  19. Kenneth D. West & Whitney K. Newey, 1995. "Automatic Lag Selection in Covariance Matrix Estimation," NBER Technical Working Papers 0144, National Bureau of Economic Research, Inc.
  20. Whitney K. Newey & Kenneth D. West, 1986. "A Simple, Positive Semi-Definite, Heteroskedasticity and AutocorrelationConsistent Covariance Matrix," NBER Technical Working Papers 0055, National Bureau of Economic Research, Inc.
  21. Kathryn Dominguez & Freyan Panthaki, 2005. "What Defines "News" in Foreign Exchange Markets?," NBER Working Papers 11769, National Bureau of Economic Research, Inc.
  22. Philippe Bacchetta & Eric van Wincoop, 2003. "Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?," Working Papers 03.02, Swiss National Bank, Study Center Gerzensee.
  23. 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.
  24. Martin D. D. Evans & Richard K. Lyons, 2007. "Exchange Rate Fundamentals and Order Flow," NBER Working Papers 13151, National Bureau of Economic Research, Inc.
  25. Charles Engel & Kenneth D. West, 2004. "Taylor Rules and the Deutschmark-Dollar Real Exchange Rate," NBER Working Papers 10995, National Bureau of Economic Research, Inc.
  26. 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.
  27. Evans, Martin D.D. & Lyons, Richard K., 2008. "How is macro news transmitted to exchange rates?," Journal of Financial Economics, Elsevier, vol. 88(1), pages 26-50, April.
  28. Richard Payne, 2003. "Macroeconomic news, order flows and exchange rates," FMG Discussion Papers dp475, Financial Markets Group.
  29. 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.
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