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Exchange Rate Supply and Demand: Who Moves Exchange Rates?

Author

Listed:
  • Vania Stavrakeva

    (London Business School)

  • Jenny Tang

    (Federal Reserve Bank of Boston)

Abstract

Exchange rates, as any other market-driven price, are determined by an equilibrium of supply and demand. Based on a model of currency derivative markets with heterogeneous agents, which is strongly supported by the data, we present a novel empirical exchange rate decomposition. Using this model, we can attribute most of the variation in exchange rate changes to broker-dealer clients' currency expectations (speculative demand) and hedging demand for over-the-counter currency derivative contracts and, to a lesser extent, to momentum trading by speculators in currency futures markets. We show that in order to understand the behavior of exchange rates, it is crucial to introduce deviations from full information rational expectations (FIRE) in exchange rate models, as deviations from FIRE play an important role in explaining both the expectations of the broker dealer OTC clients and the presence of momentum traders in the foreign exchange rate market.

Suggested Citation

  • Vania Stavrakeva & Jenny Tang, 2019. "Exchange Rate Supply and Demand: Who Moves Exchange Rates?," 2019 Meeting Papers 388, Society for Economic Dynamics.
    • Handle: RePEc:red:sed019:388
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