Historically, the fields of exchange-rate economics and microstructure finance have progressed independently of each other. Recent interaction, however, has given rise to a microstructure approach to exchange rates. This book focuses on the economics of financial information and how microstructure tools help to clarify the types of information most relevant to exchange rates. The microstructure approach views exchange rates from the perspective of the trading room, the place where exchange rates are actually determined. Emphasizing information economics over institutional issues, the approach departs from three unrealistic assumptions common to previous approaches: that all information relevant to exchange rates is publicly available, that all market participants are alike in their goals or in how they view information, and that how trading is organized is inconsequential for exchange rates. The book shows how exchange-rate behavior previously thought to be particularly puzzling can be explained using the microstructure approach. It contains a combination of theoretical and empirical work.

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The Microstructure Approach to Exchange Rates

most (all?) behavior can be explained by assuming that agents have stable, well-defined preferences and make rational choices consistent with those preferences in markets that (eventually) clear. An empirical result qualifies as an anomaly if it is difficult to "rationalize," or if implausible assumptions are necessary to explain it within the paradigm. This column will present a series of such anomalies. Readers are invited to suggest topics for future columns by sending a note with some reference to (or better yet copies of) the relevant research. Comments on anomalies printed here are also welcome. The address

https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.4.3.179

Anomalies: Foreign Exchange

Macroeconomic models of nominal exchange rates perform poorly. In sample, R2 statistics as high as 10 percent are rare. Out of sample, these models are typically out-forecast by a naive 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 of microstructure—order flow. Order flow is the proximate determinant of price in all microstructure models. This is a radically different approach to exchange rate determination. It is also strikingly successful in accounting for realized rates. Our model of daily exchange-rate changes produces R2 statistics above 50 percent. Out of sample, our model produces significantly better short-horizon forecasts than a random walk. For the DM/$ spot market as a whole, we find that $1 billion of net dollar purchases increases the DM price of a dollar by about 1 pfennig.

/pdf/order-flow-and-exchange-rate-dynamics-3qqw45081z.pdf

Order Flow and Exchange Rate Dynamics

This paper measures the degree of price discrimination across export destinations that is associated with exchange rate changes using U.S., U.K., German and Japanese industry-level data. Given the industries sampled more price discrimination across destinations is observed in the U.K., German and Japanese data. For industries that match across source countries, however, behavior is very similar across source countries. Furthermore, destination-specific price adjustment on exports to the U.S. from Germany and Japan is similar to price adjustment observed on shipments to other destinations. Most variation in the data appears to be related to industry.

International Comparisons of Pricing-to-Market Behavior

Fixed exchange rates are less volatile than floating rates. But the volatility of macroeconomic variables such as money and output does not change very much across exchange rate regimes. This suggests that exchange rate models based only on macroeconomic fundamentals are unlikely to be very successful. It also suggests that there is no clear tradeoff between reduced exchange rate volatility and macroeconomic stability.

Fixing Exchange Rates: A Virtual Quest for Fundamentals

The international monetary landscape that has emerged since the felling of Bretton Woods is characterized by a hybrid exchange rate system that lies somewhere between the textbook polar cases of a gold standard and a pure float. This system has relatively flexible exchange rates between major countries, active central bank intervention in the market for the major currencies, and predominantly fixed exchange rates (relative to the dollar or to some basket of currencies) for less developed countries and newly industrializing nations. The majority of research on currency markets since the early 1970s has focused on the characteristics of flexible exchange rates under this hybrid regime. My thesis is that this research has been unsuccessful. The proportion of (monthly or quarterly) exchange rate changes that current models can explain is essentially zero. Even after-the-fact forecasts that use actual values (instead of forecasted values) of the explanatory variables cannot explain major currency movements over the post-Bretton Woods era. This result is quite surprising, since exchange rate changes would be entirely unpredictable only in very special cases of the theoretical models discussed. As the discussion below will argue, it is not a general implication of market efficiency that exchange rates follow a random walk process.1

https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.4.1.117

Richard Meese

Papers

Currency Fluctuations in the Post-Bretton Woods Era