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Handbook of Exchange Rates
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Handbook of Exchange Rates

by Jessica James, Ian Marsh, Lucio Sarno
July 2012
Beginner content levelBeginner
856 pages
27h 22m
English
Wiley
Content preview from Handbook of Exchange Rates

3.4 Exchange Rates, Order Flows, and the Macro Economy

Microstructure exchange-rate models, such as the PS model, are silent on the potential links between the macro economy and order flows, because they focus on the details of currency trading between different market participants rather than the macro economic factors that ultimately drive the individual trades. More specifically, all the information conveyed by order flow in the PS model concerns the risk premium dealers embed in their spot-rate quotes. Thus, from the perspective of the PS model, the correlation between depreciation rates and order flows observed in the data is attributable to the role that order flow plays in driving the last term on the right-hand side of Equation (3.6):

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Clearly, this is a rather narrow perspective. The observed correlation between depreciation rates and order flows could also reflect the fact that order flow conveys information about current and future fundamentals (i.e., via the terms in the second row in the above equation). To address this possibility, recent micro-based research focuses on the role that order flow plays in conveying macro information. This research builds on two central ideas: (i) Only some of the macro information relevant for the current spot rate is publicly known at any point in time. Other information is present in the economy, but it exists in a dispersed microeconomic ...

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