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Publications (81)
Models of currency competition focus on the 5% of trading attributable to balance-of-payments flows. We introduce an information approach that focuses on the other 95%. Important departures from traditional models arise when transactions convey information. First, prices reveal different information depending on whether trades are direct or though...
Macro news can affect currency prices directly and indirectly via order flow. Past research shows that the direct effects of scheduled macro news account for less than 10% of daily price variance. This paper shows that the arrival of macro news can account for more than 30% of daily price variance. Two features of our analysis account for this find...
The article discusses service innovation in the investment banking industry. Service industry innovations differ from innovations in industries that produce physical products because they rarely have intellectual property and patent protections. However, investment banking services are typically a series of interrelated businesses such as consultin...
We address whether transaction flows in foreign exchange markets convey fundamental information. Our GE model includes fundamental information that first manifests at the micro level and is not symmetrically observed by all agents. This produces foreign exchange transactions that play a central role in information aggregation, providing testable li...
We address four common misconceptions about micro-based research on exchange rates: (1) public news arrivals account for most exchange rate variation; (2) allocative trades do not convey information; (3) or-der flow is easy to measure; and (4) transactions obviously drive prices. Though few people subscribe to all four, most people subscribe to at...
When information about fundamentals is symmetric, can information-based trade still arise? Consider bond and foreign exchange (FX) markets, where private information about nominal cash flows is generally absent, but participants are convinced that superior information exists. We analyze a class of asymmetric information—inventory information—that i...
This paper develops a model for understanding end-user order flow in the FX market. The model addresses several puzzling findings. First, the estimated price-impact of flow from different end-user segments is, dollar-for-dollar, quite different. Second, order flow from segments traditionally thought to be liquidity-motivated actually has power to f...
Supervised by Rudiger Dornbusch. Thesis (Ph. D.)--Massachusetts Institute of Technology, Dept. of Economics, 1988. Includes bibliographical references (leaves 120-125).
We identify incentives generated by the Bretton Woods II system that may have contributed to the sub-prime liquidity crisis now working its way through the international monetary system. We then evaluate the persistent conjecture that the liquidity crisis is or will become a balance of payments crisis for the United States. Given that it happens, t...
This paper addresses whether macro news arrivals affect currency markets over time. The null from macro exchange rate theory is that they do not: macro news is impounded in exchange rates instantaneously. We test this by examining the effects of news on subsequent trades by end-user participants (such as hedge funds, mutual funds, and non-financial...
Discussions of the different theoretical and empirical paradigms for setting and predicting exchange rates.
Recent theoretical developments in exchange rate economics have led to important new insights into the functioning of the foreign exchange market. The simple models of the 1970s, which could not withstand empirical evaluation, have been succe...
The 2008/9 financial crisis highlighted the importance of evaluating vulnerabilities owing to interconnectedness, or Too-Connected-to-Fail risk, among financial institutions for country monitoring, financial surveillance, investment analysis and risk management purposes. This paper illustrates the use of balance sheet-based network analysis to eval...
We address the exchange rate determination puzzle by examining how information is aggregated in a dynamic general equilibrium (DGE) setting. Unlike other DGE macro models, which enrich either preference structures or production structures, our model enriches the information structure. The model departs from microstructure-style modeling by identify...
When information about fundamentals is symmetric, can information-based trade still arise? Consider bond and FX markets, where private information about nominal cash flows is generally absent, but participants are convinced that superior information exists. We analyze a class of asymmetric informationinventory informationthat is unrelated to fundam...
Macroeconomic models of nominal exchange rates perform poorly. In sample, R statistics as high as 10 percent are rare. Out of sample, these models are typically out-forecast by a nave random walk. This paper presents a model of a new kind. Instead of relying exclusively on macroeconomic determinants, the model includes a determinant from the field...
This paper addresses international financial integration in a new way. We focus on informational integration, specifically, the importance of information conveyed by order flow in major currencies for pricing minor currencies. We develop a multi-currency model of portfolio allocation in the presence of dispersed information. We then test the model'...
This paper summarizes key lessons learned from using models from microstructure finance to explain and forecast exchange rates. The first section is an executive summary, which outlines seven lessons that pertain to how different transaction-flow measures (e.g., interbank flows versus end-user flows) perform in explaining concurrent returns and for...
We examine the trading strategies of mutual funds in emerging markets. We develop a method for disentangling the behavior of fund managers from that of underlying investors. For both managers and investors, we strongly reject the null hypothesis of no momentum trading: mutual funds systematically sell losers and buy winners. Selling current losers...
International mutual funds are key contributors to the globalization of financial markets and one of the main sources of capital flows to emerging economies. Despite their importance in emerging markets, little is known about their investment allocation and strategies. This paper provides an overview of mutual fund activity in emerging markets. Fir...
century. These crises were not confined to individual nations, or even regions. The Thai crisis engulfed---within days---Malaysia, Indonesia, and the Philippines. The Russian crisis spread as fast to countries as far apart as Brazil and Pakistan. Even developed countries have been affected, with the Russian default/devaluation reverberating in fina...
This paper provides a new test for whether different-currency assets are imperfect substitutes. The test exploits that under floating rates, changing public currency demand has no direct effect on monetary fundamentals, current or future. Price effects from imperfect substitutability are clearly present: the immediate price impact of public trades...
We identify incentives generated by the Bretton Woods II system that may have contributed to the sub-prime liquidity crisis now working its way through the international monetary system. We then evaluate the persistent conjecture that the liquidity crisis is or will become a balance of payments crisis for the United States. Given that it happens, t...
This paper addresses the puzzle of regime-dependent volatility in foreign exchange. We extend the literature in two ways. First, our microstructural model provides a qualitatively new explanation for the puzzle. Second, we test implications of our model using Europe's recent shift to rigidly fixed rates (EMS to EMU). In the model, shocks to order f...
This paper addresses the future of the foreign exchange market using two orga-nizing (and provocative) ideas. One pertains to the market's institutional struc-ture, the other to its information structure. The first organizing idea is that the structure of currency markets is driven primarily by the management of credit risk. This contrasts with dri...
This paper addresses whether currency trades have greater price impact when public information is flowing rapidly. We develop an optimizing model to account for why public news should increase the price impact of trades. Using transaction data made available by electronic trading, we test whether trades following macroeconomic news have higher pric...
This paper addresses international financial integration in a new way. We focus on informational integration, specifically, the importance of information conveyed by order flow in major currencies for pricing minor currencies. We develop a multi-currency model of portfolio allocation in the presence of dispersed information. We then test the model’...
This paper presents an exchange rate model of a new kind. Instead of relying exclusively on macroeconomic determinants, the model includes a determinant from the field of microstructure financeorder flow. Order flow is a determinant because it conveys information. This is a radically different approach to exchange rates. It is also strikingly succe...
Forex markets and the euro
Theoretical prespective
I provide theoretical perspective on recent findings of increased transaction costs in the new dollar-euro market relative to the prior dollar-mark market, and assess the welfare significance of this drop in liquidity. In theory, transaction costs arise from information disadvantage costs, inventor...
This paper reviews recent progress in applying information-theoretic tools to long-standing exchange rate puzzles. I begin by distinguishing the traditional public information approach (e.g. monetary models, including new open economy models) from the newer dispersed information approach. (The latter focuses on how information is aggregated in the...
This paper addresses international financial integration in a new way. Past work on integration focuses either on speculative integration or on geographic integration. Our analysis focuses instead on informational integration. We de-velop a multi-currency model of portfolio allocation in the presence of dispersed information (therein making our def...
Evans and Lyons (1999) find that order flow accounts for about two-thirds of varia-tion in the DM/$ rate. Though never tested, the underlying cause of order flow in their model is portfolio shifts unrelated to macroeconomic information (e.g., shifts in risk preferences or shifts in hedging demands). This paper tests whether order flow is caused (in...
We extend the literature on regime-dependent volatility in two ways. First, our microstructural model provides a qualitatively new explanation. Second, we test implications of our model using Europe's recent shift to rigidly fixed rates (EMS to EMU). In the model, shocks to order flow induce more volatility under flexible rates because the elastici...
This special issue is dedicated to a topic of great interest in international financial economics — Capital Market Integration. The topic remains live and vigorously examined, as evidenced by the nine papers presented here. These papers divide into three themes: integration and markets, integration and policy, and integration and crisis. Collective...
This paper tests the portfolio-balance approach to exchange rate determination in a new way. Past work on portfolio balance in foreign exchange falls into two groups: (1) tests using measures of asset supply and (2) tests using measures of central-bank asset demand. We address the demand side, but we use a broad measure of public demand, rather tha...
Though fundamental and technical analysis are still widely used in foreign exchange markets, a new type of analysis has emerged: order -flow analysis. Order-flow analysis uses the flow of buy and sell orders to both explain exchange rates contemporaneously and forecast future movements. This article contrasts order-flow analysis with the traditiona...
International mutual funds are one of the main channels of capital flows to emerging economies. Although mutual funds have become important contributors to financial-market integration, little is known about their investment allocation and strategies. This paper provides an overview of mutual fund activity in emerging markets. First, we describe th...
We use new data on FF/DM order flow in 1998 (the year before EMU) to show that while the rate was flexible, order flow had persistent effects. After the May announcement of the conversion rates, FF/DM behaved like a fixed rate, in the sense that it was decoupled from order flow. We develop a model to reconcile these before-vs-after observations. Th...
Contents Preface Chapter 1: Overview of the Microstructure Approach 1.1 Three Approaches to FX: Goods, Assets, and Microstructure 1.2 Hallmarks of the Microstructure Approach 1.3 Overarching Themes 1.4 Applying Microstructure Tools to Exchange-Rate Puzzles 1.5 Spanning the Micro-Macro Divide Chapter 2: The Economics of Order-Flow Information 2.1 Ba...
Central-bank intervention always introduces asymmetric information. There are no plausible, common-knowledge alternatives, regardless of intervention type (e.g announced vs. unannounced), and regardless of efficacy channel (e.g., portfolio vs information). This paper recasts intervention analysis into a framework of asymmetric information. This all...
July 2000This study of an important class of investors-U.S. mutual funds-finds that mutual funds do engage in momentum trading (buying winners and selling losers). They also engage in contagion trading strategies (selling assets from one country when asset prices fall in another). Kaminsky, Lyons, and Schmukler address the trading strategies of mut...
This chapter uses implied volatilities to examine both the existence and form of the currency risk premium. First, I test for "simple efficiency", under which there is no risk premium and expectations are rational. This involves testing whether implied volatilities predict subsequent excess returns on currency positions. I find they do, a rejection...
Macroeconomic models of nominal exchange rates perform poorly. In sample, R 2 statistics as high as 10 percent are rare. Out of sample, these models are typically out-forecast by a naïve random walk. This paper presents a model of a new kind. Instead of relying exclusively on macroeconomic determinants, the model includes a determinant from the fie...
This paper presents an exchange rate model of a new kind. Instead of relying exclusively on macroeconomic determinants, the model includes a determinant from the field of microstructure finance-order flow. Order flow is a determinant because it conveys information. This is a radically different approach to exchange rates. It is also strikingly succ...
Dealers need to search for quotes in many of the world's largest markets (such as spot foreign exchange, US government bonds, and the London Stock Exchange). This search affects trading cost. We estimate the share of total trading cost attributable to search. Our experiments show that the share is large---roughly one-third of the effective spread....
We provide evidence of private information in the foreign exchange market. The evidence comes from the introduction of trading in Tokyo over the lunch hour. Lunch-return variance doubles with the introduction of trading, which cannot be due to public information since the flow of public information did not change with the trading rules. We then exp...
The paper decomposes GDP both in terms of level per capita and growth rate, so as to identify the sources of income differences and of economic growth for all EU27 member states. This accounting approach has multiple advantages, although a number of substantial caveats should be borne in mind when interpreting the results. In particular, the detail...
This paper develops a simultaneous trade model of the spot foreign exchange market (cf., the sequential trade approach to dealing). The model produces hot-potato trading – a term that refers to the repeated passing of inventory imbalances between dealers. At the outset, risk-averse dealers receive customer orders that are not generally observable....
It is a common view that private information in the foreign exchange market does not exist. We provide evidence against this view. The evidence comes from the introduction of trading in Tokyo over the lunch-hour. Lunch return variance doubles with the introduction of trading, which cannot be due to public information since the flow of public inform...
This paper addresses a fundamental tradeoff in the design of multiple-dealer markets. Namely, though greater transparency can accelerate revelation of information in price, it can also impede dealer risk management. If dealers could choose the transparency regime ex-ante, which regime would they choose? We show that dealers prefer incomplete transp...
Intraday interest rates are zero. Consequently, a foreign exchange dealer can short a vulnerable currency in the morning, close this position in the afternoon, and never face an interest cost. This tactic might seem especially attractive in times of fixed‐rate crisis, since it suggests an immunity to the central bank's interest rate defense. In equ...
Intraday interest rates are zero. Consequently, a foreign exchange dealer can short a vulnerable currency in the morning, close this position in the afternoon, and never face an interest cost. This tactic might seem especially attractive in times of fixed-rate crisis, since it suggests an immunity to the central bank's interest rate defense. In equ...
Data in this paper support both the inventory-control and asymmetric-information approaches to microstructure theory. Strong evidence of an inventory-control effect on price is new. The transactions dataset chronicles a trading week of a spot foreign exchange dealer whose daily volume averages over $1 billion. In addition to controlling inventory w...
This paper examines whether currency trading volume is informative, and under what circumstances. Specifically, we use transactions data to test whether trades occurring when trading intensity is high are more informative -- dollar for dollar -- than trades occurring when intensity is low. Theory admits both possibilities, depending primarily on th...
Intra-day interest rates are zero. Consequently, a foreign exchange dealer can short a vulnerable currency in the morning, close this position in the afternoon, and never face an interest cost. This tactic might seem especially attractive in times of crisis, since it suggests an immunity to the central bank's interest rate defence. In equilibrium,...
This paper develops a two-period model of the spot foreign exchange market that emphasizes inter-dealer trading. At the outset, strategic risk-averse dealers each receive orders from non-dealer customers that are not generally observable. Then, dealers trade among themselves. Thus, each dealer intermediates his own customers' order-flow information...
Using a monetary model in the spirit of Dornbusch (1976) and a sunk cost model of trade hysteresis we show that a sufficiently large policy misalignment can induce hysteresis in the trade balance and thereby alter the steady-state real exchange rate. Hence, exchange rate dynamics are path dependent. Since hysteresis in our model can entail industri...
This paper addresses the issue of optimal transparency in a multiple-dealer market. In particular, we examine the question: Would risk-averse dealers prefer ex-ante that signed order flow were observable? We answer this question with the solution to a mechanism design problem. The resulting incentive-efficient mechanism is one in which signed order...
Three potentially complementary models are tested in an effort to capture the fundamentals that underlaid the market's determination of Peru's floating exchange rate through the period 1950–1954 the first is an expectational purchasing power parity (PPP) model which maintains that asset market forces were driving the exchange rate to its perceived...
An information externality exists in the foreign exchange market due to the fact that traders play two partially conflicting roles: (i) each is a speculator and (ii) each is an information clearinghouse in that each intermediates own-customer orders which convey information. Profit maximization induces traders to underweight fundamental information...
In this paper we build upon previous work on external economies in manufacturing [Caballero and Lyons (1989, 1990)] by providing new evidence helpful for discriminating between different types of externalities. We investigate four-digit level input-output relationships and find that, over shorter horizons, the linkage between an industry and its cu...
In this paper we highlight a new dimension of the aggregate procyclical productivity phenomenon. We show that estimates of the degree of returns to scale are larger for manufacturing as a whole than for two-digit industries. Since this difference must be due to factors that are only internalized at the most aggregate level, we term it an external e...
It is often suggested that "European economic and monetary integration is important because people think it is". This paper is an exploratory attempt to formalize this idea. As the basis for our investigation, we rely on recent analysis by Krugman (1989) and Matsuyama (1989), which addresses the process of equilibrium determination in a stylized ec...
Money stock innovations have two principal impact effects on the exchange rate. One is the direct effect as captured by the overshooting hypothesis. The second is the result of the change in money growth rate expectations induced by the stock innovation. Simulations using a stylized monetary process verify that the front-end loading of the growth r...
This paper develops a method for joint estimation of both the degree of internal returns to scale and the extent of external economies. We apply the method in estimating returns to scale indexes for U.S. manufacturing industries at the two-digit level. Overall, we find that only three of the twenty industry categories show any evidence of internal...
This paper presents estimates of indexes of internal returns to scale and external economies for two-digit manufacturing industries in the four European countries for which the requisite data are available in adequate length: West Germany, France, the U.K., and Belgium. Overall, we find very little evidence of internal increasing returns to scale:...
Using the sticky price monetary model of exchange rate determination and the sunk cost model of trade hysteresis, we show that a sufficiently large policy misalignment can induce hysteresis in the trade balance and thereby alter the steady?state real exchange rate. Thus in our model exchange rate dynamics are path dependent, PPP need not hold and m...
The volatility of flexible exchange rates greatly exceeds what most analysts anticipated at the advent of generalized floating. The Dornbusch overshooting model accounts for the fact that exchange rates fluctuate more than the underlying fundamentals. This paper presents a model which may help account for why exchange rates have been even more vola...
This paper utilizes the second moment expectations implied by currency option pricing to demonstrate that these expectations are systematically related to expected return differentials across assets denominated in different currencies. Because the measured deviations from uncovered interest rate parity are tied to variables which theory links to th...
We study the macroeconomic information conveyed by transaction flows in the foreign exchange market. We present a new genre of model for the concurrent empirical link between spot prices and transaction flows that produces two new implications for forecasting: (i) transaction flows should have incremental forecasting power for future fundamentals r...
Central-bank intervention always introduces asymmetric information. There are no plausible, common-knowledge alternatives, regardless of intervention type (e. g announced vs. unannounced), and regardless of efficacy channel (e. g., port-folio vs information). This paper recasts intervention analysis into a framework of asymmetric information. This...