New Micro Exchange Rate Economics - PowerPoint PPT Presentation

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New Micro Exchange Rate Economics

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Keynote Address March 2003 Richard K. Lyons U.C. Berkeley and NBER These s and other resources in New Micro (e.g., working paper clearinghouse) are available at: – PowerPoint PPT presentation

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Title: New Micro Exchange Rate Economics


1
New Micro Exchange Rate Economics
  • Keynote Address
  • March 2003
  • Richard K. Lyons
  • U.C. Berkeley and NBER
  • These slides and other resources in New Micro
    (e.g., working paper clearinghouse) are available
    at
  • faculty.haas.berkeley.edu/lyons

2
New Micro Introduction
  • Information Focus
  • (1) What is the nature of the information the FX
    market is aggregating?
  • (2) How does it achieve this aggregation?
  • Tools
  • Largely from microstructure finance
  • Provides theoretical and empirical guidance

3
Information Focus
  • (1) Public domain current macro variables
  • But inflation, Y, Ms, and NX are micro data
    aggregated months later by official inst. Any
    impounding in price in the meantime?
  • Also, what about disagreement on implications,
    even if observed simultaneously?
  • (2) Public domain future macro variables
  • How are variations in individuals expectations
    impounded in price if not common knowledge?
  • (3) Non-public domain asset pricing variables
  • What about shocks to money demands, shocks to
    hedging demands, or shocks to risk prefs? How are
    these impounded in price?
  • (4) Non-public domain other variables
  • What about information regarding the strategic
    choices of others, or information about
    behaviorally-motivated actions of others, how are
    these impounded in price?

4
Modern Exch. Rate Economics

Modern ER Econ.
Micro-founded
Non-rational
New Micro
New Macro
  • Focus info econ. of fin. markets
  • Info structure dispersed info
  • Disconnect Q why macro so little ER impact?
  • Focus sub-opt. behavior
  • Approach trending from noise, feedback,
    chartism to behavioral econ.
  • Focus supply side of real econ.
  • Info structure CK (com. knowl.)
  • Disconnect Q why ER so little macro impact?

5
Order Flow An Information Vehicle
  • (1) Order flow is sum of signed trades (not
    volume)
  • Signed according to which side initiates
  • Quoting marketmaker is non-initiating side
  • Auction structure limit order is non-initiating
  • (2) Order flow is not the same as net demand
  • OF measures transactions (i.e., demands after
    price has adjusted)
  • Think of overshooting model ? demand ? ? in
    s price, but no executed transactions initiated
    by buyers along the way, nor any imbalance in
    dollar buying at the new price.
  • Unlike net demand, cum. OF may ? 0
  • In some models cum. OF follows RW
  • Price impact differs depending on trader identity
  • Link to info econ whose trades info rich?
  • (3) Another perspective information is in the
    shifts
  • How ID demand and supply curves?
  • Think of scatter in P-Q space
  • Exclusion restrict. shifts (vs moving along)
  • Microstructure theory IDs shifting

6
Order Flows Role Graphically
Macro Approach

Microstructure Approach
Private info
Price
Order flow
Hybrid
Information
Price
Order flow
7
New Micro Frequently Asked Questions
  • Isnt order flow just demand?
  • No, as addressed earlier (transactions?demand)
  • With two sides to every trade, what can we learn?
  • True, but they need not be symmetric one side
    may be a demand curve shift, the other a
    price-induced movement along a stable demand
    curve
  • Price impounds info in the shift
  • But isnt order flow an endogenous variable?
  • Yes, but so are all the traditional macro
    variables we have been using in empirical
    exchange rate models (e.g., output, money,
    interest rates, and inflation).
  • The key is determining the underlying shocks
    (information) that drive order flow.
  • Strategies for doing so are outlined below
  • Might causality also go in reverse, from price to
    order flow?
  • Surely the answer is yes. For example, price
    changes induce movements along demand curves,
    which can in turn produce initiated trades, i.e.,
    order flow. Price changes can also cause demand
    curves to shift, e.g., at times of market stress
    (due to capital constraints, etc.).
  • On average, price-induced order flow in FX data
    appears to be negative (Evans and Lyons 2002 JME,
    2003 NBER Tien 2002)
  • So reverse causality does not account for the
    strong positive correlation between OF and ER
    changes.
  • Dont lose perspective that causality can run
    both ways does not mean that order flow is not
    the cause of most ER variation.

8
New Micro Frequently Asked Questions
  • Can the info conveyed by flow be fundamental?
  • Yes, even if fundamental is defined narrowly to
    mean money supply and income (Ms and Y).
  • 2 examples above (1) micro data not yet
    officially aggregated and (2) individuals
    changing expectations of future M and Y
  • There is evidence that flows forecast future U.S.
    money growth and real output (Evans and Lyons NSF
    2003)
  • Even if not reflecting narrow fundamentals, OF
    can convey info about mkt-clearing risk premia (a
    la Portfolio Balance models)
  • Examples above shocks to hedging demands and to
    risk preferences
  • PB effects not traditionally called fundamental
  • As empirical question, remains open
  • Do order flow effects on ERs persist?
  • Theory persistence depends on info type
  • Distinguish nominal ER effects from real
  • Data much evidence that nominal ER effects do
    persist (Evans and Lyons 2002 JPE, Payne JIE
    forthcoming, Killeen et al. 2001 NBER, Froot and
    Ramadorai 2002 NBER).
  • Multi-year plots are not consistent with impact
    that fades in months or less levels would not
    track over years unless impact persists over
    years
  • Profits Rapid mean reversion of OF effects would
    imply trading strategies so profitable that
    theyre unrealistic

9
What Info Drives Order Flow?
  • 4 Lines of Empirical Attack (so far)
  • (1) Macro news OF less important then?
  • Empirical may be more importanthelps market
    aggregate differential interpretations
  • Example on next slide
  • (2) Disaggregate OF identity matters?
  • Empirical differential price impact across
    trader types shows which types best informed
  • (3) Cross Currency / trades info for /?
  • Empirical pattern of cross-market effects shows
    whether info specific to , , or
  • (4) Macro expectations OF proxy changes?
  • Price depends expected future macro
  • OF measures expectational votes over time?

10
Does Macro News Drive Order Flow?
Total Variation 10 20 40 30
_______ 100
  • (1) Public news impounded immediately and
    directly
  • (2) Public news impounded via OF
  • (3) OF unrelated to macro news (à la Evans
    Lyons 2002 JPE)
  • (4) Dont know

See Evans and Lyons, How is Macro News
Transmitted to Exchange Rates (NBER 9433, Jan.
2003) for estimation details.
11
Taxonomy of Information Types
  • Traditional split public vs private
  • Public to be impounded in price without order
    flow role, not only must data be commonly
    observed, but traders must also agree on ER
    implications (i.e., plenty of room for OF role).
  • Private as noted, many sub-categories within
  • Private information 2x2

Note in a risk neutral world, only the payoff
column is relevant.
12
From Causes to Consequences
  • Thus far work mostly on identifying the causes of
    order flows information role
  • E.g., identifying the underlying information that
    causes flow.
  • But what are the consequences of order flow
    conveying information?
  • Application International Currencies
  • Why do some currencies play a disproportionate
    international role?
  • Big question with a long history
  • Does the finding that order flow conveys
    information have any implications?

13
Information Approach to Intl Currencies
  • Paper (with Michael Moore) addresses a specific
    dimension of the international role of
    currencies the pattern of cross-currency
    exchange.
  • Currency competition outcomes driven by relative
    transaction costs across markets.
  • Information approach is radically different from
    two traditional approaches.
  • Market-size approach (e.g., Krugman 1980 JMCB,
    Rey 2001 RES) transaction costs are a decreasing
    function of total volume traded.
  • Emphasis on resulting increasing returns and
    multiple equilibria more trade reduces trans
    costs, which promotes more trade.
  • Marketmaker-risk approach (e.g., Black 1991 JIMF
    and Hartmann 1998 CUP book) adds exchange rate
    volatility to the determinants of transaction
    costs.

14
Analytical Results
  • Indeterminacy Info dimension resolves
    traditional indeterminacy of currency trade
    patterns (by mitigating the concentrating force
    of market size economies).
  • Asset Trade Pattern of currency trade not
    driven by the pattern of real trade, as in
    traditional models, but instead by the pattern of
    asset trade.
  • Exchange Rate Whether transactions are executed
    directly or indirectly effects exchange rate
    determination (because these trading methods do
    not reveal the same information).
  • Missing Markets Model provides a new rationale
    for why some currency pairs never trade directly
    information is not sufficiently symmetric to
    induce participation.

15
Empirical Results
  • Paper is first integrated analysis of
    transactions in a triangle of markets (, , )
  • Predictions
  • Coefficient signs
  • Matrix positive semi-definite
  • Matrix symmetric
  • Table 1
  • Coefficient signs all correct (and significant)
  • Semi-definiteness borne out
  • Problems with symmetry
  • 86 is ratio of indirect to direct / trading

16
Concluding Remarks
  • Strength of New Micro is its empirical basis
  • Caveat of data availability
  • Theoretical work behind, but catching up
  • E.g., Hau Rey (here), Bacchetta van Wincoop
    (2002)
  • Much being done, both causes consequences
  • Outward reaching
  • New macro models
  • Asset pricing
  • Traditional portfolio balance models
  • Behavioral finance
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