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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.

Suggested Citation

  • Evans, Martin D.D., 2010. "Order flows and the exchange rate disconnect puzzle," Journal of International Economics, Elsevier, vol. 80(1), pages 58-71, January.
  • Handle: RePEc:eee:inecon:v:80:y:2010:i:1:p:58-71
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    More about this item

    Keywords

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

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange

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