Title: New Micro Exchange Rate Economics
1New 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
2New 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
3Information 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?
4Modern 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?
5Order 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
6Order Flows Role Graphically
Macro Approach
Microstructure Approach
Private info
Price
Order flow
Hybrid
Information
Price
Order flow
7New 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.
8New 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
9What 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?
10Does 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 (Ã 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.
11Taxonomy 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.
12From 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?
13Information 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.
14Analytical 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.
15Empirical 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
16Concluding 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