What economists can learn from currency traders

A recent Economist economics focus column, Marking the dealer's cards, argued that economists can learn from currency traders. This is contrary to what the classic 1983 Meese and Rogoff paper might suggest - it found that macro exchange rate models were no better than naive forecasts. The Economist briefly talks about the microstructure approach to currency research, which looks at order flows, but the piece barely scratched the surface.

This is one of the most interesting research areas in financial economics at the moment. Where do you go to find more? A good place to start is the excellent New Micro Exchange Rate Economics website and links, along with the websites of Richard K Lyons (Berkeley) and Martin D. D. Evans (Georgetown).

But for good introductory reading I would recommend two papers published earlier this year. The first, Foreign Exchange Market Microstructure (PDF), was prepared by Martin D. D. Evans for the second edition of the New Palgrave Dictionary of Economics:

This paper provides an overview of the recent literature on Foreign Exchange Market Microstructure. Its aim is not to survey the literature, but rather to provide an introductory tour to the main theoretical ideas and empirical results. The central theoretical idea is that trading is an integral part of the process through which information relevant to the pricing of foreign currency becomes embedded in spot rates.

Micro-based models study this information aggregation process and produce a rich set of empirical predictions that find strong support in the data. In particular, micro-based models can account for a large proportion of the daily variation in spot rates. They also supply a rationale for the apparent disconnect between spot rates and fundamentals. In terms of forecasting, micro-based models provide out-of-sample forecasting power for spot rates that is an order of magnitude above that usually found in exchange-rate models.

The second, by Lucio Sarno from Warwick Business School, Towards a Solution to the Puzzles in Exchange Rate Economics: Where Do We Stand? (PDF), is soon to appear in the Canadian Journal of Economics:

This paper provides a selective overview of puzzles in exchange rate economics. We begin with the forward bias puzzle: high interest rate currencies appreciate when one might guess that investors would demand higher interest rates on currencies expected to fall in value. We then analyze the purchasing power parity puzzle: the real exchange rate displays no (strong) reversion to a stable long-run equilibrium level.

Finally, we cover the exchange rate disconnect puzzle: the lack of a link between the nominal exchange rate and economic fundamentals. For each puzzle, we critically review the literature and speculate on potential solutions.

For those wanting to go further there are two books of note. Lucio Sarno and Mark Taylor's textbook, The Economics of Exchange Rates, Cambridge University Press, and Richard Lyons, The Microstructure Approach to Exchange Rates, MIT, are both well informed and fairly up-to-date. If you are at all interested in how financial markets really work, they will make your realise what a ripe area this is for research.

Comments

[Frank Gonzalez]

I can't resist appreciating the owners of this blog. Good information. Well Done.

Frank Gonzalez
http://www.Foreigncurrencyexchangemarket.com