Dagfinn Rime

Oxford Research Encyclopedias: Economics and Finance Doi: https://doi.org/10.1093/acrefore/9780190625979.013.318

An overview of research on the microstructure of foreign exchange (FX) markets is presented. We begin by summarizing the institutional features of FX trading and describe how they have evolved since the 1980s. We then explain how these features are represented in microstructure models of FX trading. Next, we describe the links between microstructure and traditional macro exchange-rate models and summarize how these links have been explored in recent empirical research. Finally, we provide a microstructure perspective on two recent areas of interest in exchange-rate economics: the behavior of returns on currency portfolios, and questions of competition and regulation.

Journal of International Money and Finance 69(Dec.) s. 45-68 Doi: https://doi.org/10.1016/j.jimonfin.2016.06.018

This paper examines why order flows are empirically important drivers of spot exchange rate dynamics. We consider a decomposition for the depreciation rate that must hold in any model and show that order flows will appear as important proximate drivers when they convey significant incremental information about future interest rate di↵erentials, risk premiums and/or long-run exchange rate levels (i.e., information that cannot be inferred from publicly observed variables). We estimate the importance of these incremental information flows for the EURNOK spot exchange rate using eight years of highquality, disaggregated, end-user order flow data collected by the Norges Bank.

Journal of Money, Credit and Banking 48(6) s. 1113-1134 Doi: https://doi.org/10.1111/jmcb.12328

We investigate the relation between foreign exchange (FX) order flow and the forward bias. We outline a decomposition of the forward bias according to which a negative correlation between interest rate differentials and order flow creates a time‐varying risk premium consistent with that bias. Using 10 years of data on FX order flow, we find that more than half of the forward bias is accounted for by order flow—with the rest being explained by expectational errors. We also find that carry trading increases currency‐crash risk in that order flow generates negative skewness in FX returns.

Journal of Monetary Economics 70 s. 1-21 Doi: https://doi.org/10.1016/j.jmoneco.2014.09.001

The scapegoat theory of exchange rates (Bacchetta and van Wincoop, 2004, Bacchetta and van Wincoop, 2013) suggests that market participants may attach excessive weight to individual economic fundamentals, which are picked as “scapegoats” to rationalize observed currency fluctuations at times when exchange rates are driven by unobservable shocks. Using novel survey data that directly measure foreign exchange scapegoats for 12 exchange rates, we find empirical evidence that supports the scapegoat theory. The resulting models explain a large fraction of the variation and directional changes in exchange rates in sample, although their out-of-sample forecasting performance is mixed.

Journal of International Money and Finance 49 s. 170-189 Doi: https://doi.org/10.1016/j.jimonfin.2014.05.012

The offshore renminbi (CNH) exchange rate is the exchange rate of the Chinese currency transacted outside China. We study the CNH exchange rate dynamics and its links with onshore exchange rates. Using a specialized microstructure dataset, we find that CNH is significantly affected by its order flow and limit-order imbalance. The offshore CNH exchange rate has an increasing impact on the onshore rate, and significant predictive power for the official RMB central parity rate. The CNH order flow also affects the onshore RMB exchange rate and the central parity rate. The interactions between variables are likely to be time-varying.

The Scandinavian Journal of Economics 116(2) s. 506-538 Doi: https://doi.org/10.1111/sjoe.12044

What is the role of “large players” (e.g., hedge funds) in speculative attacks? Recent work suggests that large players move early to induce smaller agents to attack. However, many observers argue that large players move late in order to benefit from interest-rate differentials. We propose a model in which large players can do both. Using data on currency trading by foreign (large) and local (small) players, we find that foreign players moved last in three attacks on the Norwegian krone during the 1990s. During the attack on the Swedish krona after the Russian moratorium in 1998, foreign players moved early. Gains by delaying attack were small, however, because interest rates did not increase.

Journal of International Money and Finance 38 s. 95-119 Doi: https://doi.org/10.1016/j.jimonfin.2013.05.004

Pacific Economic Review 17(3) s. 434-466 Doi: https://doi.org/10.1111/j.1468-0106.2012.00592.x

Journal of International Economics 80(1) s. 72-88 Doi: https://doi.org/10.1016/j.jinteco.2009.03.005

This paper adds to the research efforts that aim to bridge the divide between macro and micro approaches to exchange rate economics by examining the linkages between exchange rate movements, order flow and expectations of macroeconomic variables. The basic hypothesis tested is that if order flow reflects heterogeneous expectations about macroeconomic fundamentals, and currency markets learn about the state of the economy gradually, then order flow can have both explanatory and forecasting power for exchange rates. Using one year of high frequency data collected via a live feed from Reuters for three major exchange rates, we find that: i) order flow is intimately related to a broad set of current and expected macroeconomic fundamentals; ii) more importantly, order flow is a powerful predictor of daily movements in exchange rates in an out-of-sample exercise, on the basis of economic value criteria such as Sharpe ratios and performance fees implied by utility calculations.

Journal of Banking & Finance 33(10) s. 1741-1754 Doi: https://doi.org/10.1016/j.jbankfin.2008.10.012

This paper investigates the validity of the law of one price (LOP) in international financial markets by examining the frequency, size and duration of inter-market price differentials for borrowing and lending services (‘one-way arbitrage’). Using a unique data set for three major capital and foreign exchange markets that covers a period of more than seven months at tick frequency, we find that the LOP holds on average, but numerous economically significant violations of the LOP arise. The duration of these violations is high enough to make it worthwhile searching for one-way arbitrage opportunities in order to minimize borrowing costs and/or maximize earnings on given funds. We also document that such opportunities decline with the pace of the market and increase with market volatility.

High-Frequency Financial Econometrics s. 7-29

Journal of International Economics 76 s. 237-253 Doi: https://doi.org/10.1016/j.jinteco.2008.07.004

This paper provides real-time evidence on the frequency, size, duration and economic significance of arbitrage opportunities in the foreign exchange market. We investigate deviations from the covered interest rate parity (CIP) condition using a unique data set for three major capital and foreign exchange markets that covers a period of more than seven months at tick frequency. The analysis unveils that: i) short-lived violations of CIP arise; ii) the size of CIP violations can be economically significant; iii) their duration is, on average, high enough to allow agents to exploit them, but low enough to explain why such opportunities have gone undetected in much previous research using data at lower frequency.

Journal of International Money and Finance 24(2) s. 175-196 Doi: https://doi.org/10.1016/j.jimonfin.2004.12.003

We present evidence that non-financial customers are the main liquidity providers in the overnight foreign exchange market using a unique daily data set covering almost all transactions in the SEK/EUR market over almost 10 years. Two main findings support this: (i) the net position of non-financial customers is negatively correlated with the exchange rate, opposed to the positive correlation found for financial customers and (ii) changes in net position of non-financial customers are forecasted by changes in net position of financial customers, indicating that non-financial customers take a passive role consistent with liquidity provision. (c) 2004 Elsevier Ltd. All rights reserved.

Exchange Rate Modelling: Where do we Stand? / Paul De Grauwe, ed

Empirical Economics 30 s. 889-911 Doi: https://doi.org/10.1007/s00181-005-0005-x

Journal of Financial Economics 75(3) s. 571-605 Doi: https://doi.org/10.1016/j.jfineco.2004.08.001

We study dealer behavior in the foreign exchange spot market using detailed observations on all the transactions of four interbank dealers. There is strong support for an information effect in incoming trades. The direction of trade is most important, but we also find that the information effect increases with trade size in direct bilateral trades. All four dealers control their inventory intensively. Inventory control is not, however, manifested through a dealer's own prices in contrast to findings by Lyons (J. Financial Econ. 39(1995) 321). Furthermore, we document differences in trading styles, especially how they actually control their inventories. (c) 2004 Elsevier B.V. All rights reserved.

Sandrine Lardic and Valérie Mignon (eds.): Recent Developments on Exchange Rates

New Economy Handbook s. 471-504

Economic Policy 17 s. 536-552 Doi: https://doi.org/10.1111/1468-0327.00096