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Micro approaches to foreign exchange determination

  • Martin D. D. Evans


    (Georgetown University and NBER)

  • Dagfinn Rime

    (Norges Bank (Central Bank of Norway))

Micro-based exchange-rate research examines the determination and behavior of spot exchange rates in an environment that replicates the key features of trading in the foreign exchange (FX) market. Traditional macro exchange-rate models play little attention to how trading in the FX market actually takes place. The implicit assumption is that the details of trading are unimportant for the behavior of exchange rates over months, quarters or longer. Micro-based models, by contrast, examine how information relevant to the pricing of FX becomes reflected in the spot exchange rate via the trading process. According to this view, trading is not an ancillary market activity that can be ignored when considering exchange-rate behavior. Rather, trading is an integral part of the process through which spot rates are determined and evolve. The past decade of micro-based research has uncovered a robust and strong empirical relation between exchange rates and measures of FX trading activity. One measure in particular, order flow (i.e., the net of buyer- and seller-initiated FX trades) appears as the proximate driver of exchange-rate changes over horizons ranging from a few minutes to a few months. This finding supports the view that trading is an integral part of exchange-rate determination. It also stands in stark contrast to the well-known deficiencies of macro models in accounting for exchange-rate variations over horizons shorter than a couple of years. In this paper we provide an overview of micro-based research on exchange-rate determination. We survey both models focusing on partial equilibrium, the traditional domain of microstructure research, and recent research that focuses on the link between currency trading and macroeconomic conditions in the general equilibrium setting of modern macroeconomic models. We believe micro-based research is making some progress towards understanding the links between macroeconomic conditions and the behavior of exchange rates over macro- and policy-relevant horizons.

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Paper provided by Norges Bank in its series Working Paper with number 2011/05.

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Length: 42 pages
Date of creation: 10 May 2011
Date of revision:
Handle: RePEc:bno:worpap:2011_05
Note: First version:
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  1. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1997. "Monetary Policy Rules in Practice: Some International Evidence," CEPR Discussion Papers 1750, C.E.P.R. Discussion Papers.
  2. Martin D. D. Evans & Richard K. Lyons, 2007. "Exchange Rate Fundamentals and Order Flow," NBER Working Papers 13151, National Bureau of Economic Research, Inc.
  3. Martin D.D. Evans & Richard K. Lyons, 2005. "Do Currency Markets Absorb News Quickly?," NBER Working Papers 11041, National Bureau of Economic Research, Inc.
  4. Rime, Dagfinn & Sarno, Lucio & Sojli, Elvira, 2009. "Exchange Rate Forecasting, Order Flow and Macroeconomic Information," CEPR Discussion Papers 7225, C.E.P.R. Discussion Papers.
  5. Martin Evans and Richard K. Lyons, 2002. "Informational Integration and FX Trading," Working Papers gueconwpa~02-02-11, Georgetown University, Department of Economics.
  6. Martin D. D. Evans, 2002. "FX Trading and Exchange Rate Dynamics," Journal of Finance, American Finance Association, vol. 57(6), pages 2405-2447, December.
  7. Burnside, Craig & Eichenbaum, Martin & Kleshchelski, Isaac & Rebelo, Sérgio, 2006. "The Returns to Currency Speculation," CEPR Discussion Papers 5883, C.E.P.R. Discussion Papers.
  8. Bjonnes, Geir Hoidal & Rime, Dagfinn & Solheim, Haakon O.Aa., 2005. "Liquidity provision in the overnight foreign exchange market," Journal of International Money and Finance, Elsevier, vol. 24(2), pages 175-196, March.
  9. Bjonnes, Geir Hoidal & Rime, Dagfinn, 2005. "Dealer behavior and trading systems in foreign exchange markets," Journal of Financial Economics, Elsevier, vol. 75(3), pages 571-605, March.
  10. Menkhoff, Lukas & Schmeling, Maik, 2008. "Local information in foreign exchange markets," Journal of International Money and Finance, Elsevier, vol. 27(8), pages 1383-1406, December.
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  12. Hasbrouck, Joel, 1991. " Measuring the Information Content of Stock Trades," Journal of Finance, American Finance Association, vol. 46(1), pages 179-207, March.
  13. Esen Onur, 2008. "The role of asymmetric information among investors in the foreign exchange market," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 13(4), pages 368-385.
  14. 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.
  15. Richard Payne, 2003. "Macroeconomic news, order flows and exchange rates," FMG Discussion Papers dp475, Financial Markets Group.
  16. 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.
  17. Nick Smyth, 2009. "Order flow and exchange rate changes: A look at the NZD/USD and AUD/USD," Reserve Bank of New Zealand Discussion Paper Series DP2009/03, Reserve Bank of New Zealand.
  18. Payne, Richard, 2003. "Informed trade in spot foreign exchange markets: an empirical investigation," Journal of International Economics, Elsevier, vol. 61(2), pages 307-329, December.
  19. Jon Faust & John H. Rogers & Shing-Yi Wang & Jonathan H. Wright, 2003. "The high-frequency response of exchange rates and interest rates to macroeconomic announcements," International Finance Discussion Papers 784, Board of Governors of the Federal Reserve System (U.S.).
  20. Martin Evans, 2008. "Order Flows and The Exchange Rate Disconnect Puzzle," Working Papers gueconwpa~08-08-05, Georgetown University, Department of Economics.
  21. 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.
  22. M. Martin Boyer & Simon van Norden, 2006. "Exchange Rates and Order Flow in the Long Run," CIRANO Working Papers 2006s-07, CIRANO.
  23. Martin D.D. Evans & Richard K. Lyons, 2005. "Meese-Rogoff Redux: Micro-Based Exchange Rate Forecasting," NBER Working Papers 11042, National Bureau of Economic Research, Inc.
  24. 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.
  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. Richard H. Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary policy rules in practice," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  27. Evans, Martin D. D. & Lyons, Richard K., 2002. "Time-varying liquidity in foreign exchange," Journal of Monetary Economics, Elsevier, vol. 49(5), pages 1025-1051, July.
  28. Martin D.D. Evans & Richard K. Lyons, 1999. "Order Flow and Exchange Rate Dynamics," NBER Working Papers 7317, National Bureau of Economic Research, Inc.
  29. Jacob Gyntelberg & Mico Loretan & Tientip Subhanij & Eric Chan, 2009. "International portfolio rebalancing and exchange rate fluctuations in Thailand," BIS Working Papers 287, Bank for International Settlements.
  30. King, Michael & Sarno, Lucio & Sojli, Elvira, 2010. "Timing exchange rates using order flow: The case of the Loonie," Journal of Banking & Finance, Elsevier, vol. 34(12), pages 2917-2928, December.
  31. Cheung, Yin-Wong & Wong, Clement Yuk-Pang, 2000. "A survey of market practitioners' views on exchange rate dynamics," Journal of International Economics, Elsevier, vol. 51(2), pages 401-419, August.
  32. Breedon, Francis & Vitale, Paolo, 2010. "An empirical study of portfolio-balance and information effects of order flow on exchange rates," Journal of International Money and Finance, Elsevier, vol. 29(3), pages 504-524, April.
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