Exchange Rate Fundamentals and Order Flow (July 2004)

Martin D. D. Evans(Georgetown University and NBER) and Richard K. Lyons(U.C. Berkeley and NBER, Haas School of Business) ()
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Martin D. D. Evans(Georgetown University and NBER) and Richard K. Lyons(U.C. Berkeley and NBER, Haas School of Business): Department of Economics, Georgetown University, http://www9.georgetown.edu/faculty/evansm1/
Authors registered in the RePEc Author Service: Martin Evans and Richard K. Lyons ()

Working Papers from Georgetown University, Department of Economics

Abstract: This paper addresses the striking ability of transaction flows to explain exchange rate movements. Specifically, we examine whether this arises because transaction flows convey incremental information about fundamentals. If so, then these flows should affect price upon their realization and observation by price setters (marketmakers). Our model is a simple general equilibrium model of information aggregation that provides---in a setting of incomplete markets---a utility-based present-value representation for exchange rates. The model produces testable implications for the relationships between realized transaction flows, current and future exchange rate returns, and future fundamentals (e.g., money supplies). We then bring these implications to the data, making use of a new dataset covering over six years of transactions (which permits estimation at the monthly frequency). We find strong contemporanous effects of transaction flows on exchange rates, corroborating past findings. More importantly, we present four key findings that are both new to the literature and supportive of our model: (1) transaction flows forecast (Granger cause) future macroeconomic variables such as money growth, output growth, and inflation, (2) transaction flows forecast future exchange rates changes, and do so more effectively than forward discounts, (3) the future exchange rate components that current flows forecast are primarily the future non-flow-driven components, and (4) though flows convey new information about future fundamentals, much of this information is still not impounded in the exchange rate 9 months later. The slow pace of learning implies that abstracting from information aggregation---as is standard in exchange rate economics---is not innocuous.

Keywords: Exchange Rate Dynamics; Microstructure; Order Flow. (search for similar items in EconPapers)
JEL-codes: F3 F4 G1 (search for similar items in EconPapers)
Date: 2005-05-03
New Economics Papers: this item is included in nep-fmk and nep-ifn
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Citations: View citations in EconPapers (7)

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