How is macro news transmitted to exchange rates?

Abstract

This paper tests whether macroeconomic news is transmitted to exchange rates via the transactions process and if so, what share occurs via transactions versus the traditional direct channel. We identify the link between order flow and macro news using a heteroskedasticity-based approach, a la Rigobon and Sack (2002). In both daily and intra-daily data, order flow varies considerably with macro news flow. At least half of the effect of macro news on exchange rates is transmitted via order flow. How Is Macro News Transmitted to Exchange Rates?In macroeconomic models of exchange rates, news maps directly into prices. The effect of news on currency demands in these models is common knowledge and transactions-though perhaps engendered by the change in exchange rates-play no role in causing the change. In microeconomic models of asset prices, in contrast, transactions do play a causal role in price determination (e.g., Glosten and Milgrom 1985, Kyle 1985).The causal role arises because transactions convey information that is not common knowledge. In this paper we test whether any part of the effect of news on exchange rates is transmitted via transactions and, if so, what share is transmitted that way versus the traditional direct channel.That transactions might play a role is motivated by recent empirical work demonstrating a link between signed transaction volume (order flow) and nominal exchange rate changes. 1 In the models employed by these papers, order flow affects exchange rates as a proximate determinant. The underlying determinant, which theory labels information, is not specified, nor is it directly tested. This leaves open the nagging question of what really drives the order flow. This paper is an attempt to address that question by examining whether macroeconomic news might be a determinant of order flow. This question is distinct from whether volume is determined by news, a well-established property of many speculative markets (see, e.g., Fleming and Remolona 1999). 2 1 See, e.g., Payne (1999), Rime (2000), Evans (2002), andLyons (2002a). Order flow-a concept from microstructure finance-is the cumulation over time of signed trades. Trades are signed according to whether the initiator is buying or selling. (The marketmaker posting the quote is the non-initiating side.) For example, a sale of 1 unit by a trader acting on a marketmaker's quote is order flow of -1. In rational-expectations models, order flow is undefined because all transactions in that setting are symmetric. A large empirical literature within finance shows that signing trades this way provides considerable explanatory power (see the review in Lyons 2001).2 A volume effect is consistent with idiosyncratic portfolio rebalancing in response to news. Under rational expectations, given the immediate unbiased adjustment in price that it implies, one would not expect good news for the dollar to produce positive (or negative) order flow in the aggregate; i.e., one would not expect a relative increase in executed transactions initiated ...

Macroeconomic and market microstructure modelling of Ugandan exchange rate

“…However the sticky price monetary model (Dornbusch, 1976) posits that an increase in the interest rate differential attracts capital inflows, which result in appreciation of the domestic currency. Unlike macroeconomic models which assume that all price relevant information is publically available, micro-based models suggest that some agents may have access to private information about fundamentals or liquidity that can be exploited in the short run (Evans and Lyons, 2002;Evans and Lyons, 2008). This information is incorporated into the exchange rate during the trading process through order flow which reflects private information processing and liquidity effects emanating from management of inventories (Berger et al, 2008;Evans and Lyons, 2002;Evans and Lyons, 2008).…”

“…Unlike macroeconomic models which assume that all price relevant information is publically available, micro-based models suggest that some agents may have access to private information about fundamentals or liquidity that can be exploited in the short run (Evans and Lyons, 2002;Evans and Lyons, 2008). This information is incorporated into the exchange rate during the trading process through order flow which reflects private information processing and liquidity effects emanating from management of inventories (Berger et al, 2008;Evans and Lyons, 2002;Evans and Lyons, 2008). Order flow is the cumulative flow of transactions, signed positively or negatively depending on whether the initiator of the transaction is buying or selling foreign currency.…”

EMU-related news and financial markets in the Czech Republic, Hungary and Poland

“…Therefore, there is evidence of a lack of efficiency of stock markets in the CEEC-3, at least during their first years of existence. Hayo and Kutan (2005a) Evans and Lyons (2008) show in the context of foreign exchange markets that three sources of price movements are relevant at intradaily and daily frequencies: the direct effect of macroeconomic news, the indirect effect of macroeconomic news through a reaction of order flows and order f n our approach, we can only capture the first of these effects.…”

Order flows and the exchange rate disconnect puzzle

“…My results are also related to recent research on the relation between order ‡ows and macro data releases. Evans and Lyons (2005), Berger et al (2005), Dominguez and Panthaki (2006) and Love and Payne (2007) all …nd that macro data releases have a statistically signi…cant impact on order ‡ows, while Evans and Lyons (2008a) estimate that one-third of the variance in order ‡ow is attributable to the arrival of macroeconomic news. These results point to the presence of di¤ering views among market participants concerning the current state of the economy and its implications for currency prices.…”