Studies in Foreign Exchange Economics

Book Preface

This volume collects the academic articles I have written on exchange-rate economics over the past 25 years. Research on the behavior of exchange rates has changed considerably during this period. In the 1980s and 1990s, both empirical and theoretical research were firmly grounded in the paradigm of international macroeconomics. Here, changing macroeconomic conditions were viewed as the sole drivers of exchange-rate fluctuations. However, the limitations of this paradigm had become quite clear by the mid- 1990s. There was remarkably little evidence that macroeconomic variables had consistent strong exchange-rate effects under most circumstances. Since then, exchange-rate research has expanded into the area of finance microstructure. This work considers the behavior of exchange rates that arise from the decisions of individuals trading currencies in the foreign exchange market. These microstructure models have provided a rich array of empirical predictions concerning currency-trading patterns that were absent in earlier macro-based models. And, importantly, their predictions are strongly supported by newly available trading data. More recently, exchange-rate researchers have begun the process of integrating the insights from currency-trading models into general equilibrium macromodels. This research takes up the challenge of linking macroeconomic conditions to exchange-rate dynamics via currency trading. The articles in this volume represent my contribution to this evolving literature on exchange-rate economics.

The articles in Part I fall squarely in the traditional macrobased paradigm of exchange-rate research. Chapter 1 presents a paper co-authored with Jim Lothian that empirically studies the links between inflation and rates of exchange-rate depreciation across major currency pairs. This paper is representative of a large body of research examining the empirical characteristics of exchange rates (and other macroeconomic variables). The next two chapters present articles co-authored with Karen Lewis. This work investigates whether “peso problems” could account for the anomalous behavior of foreign currency returns, i.e., behavior that could not be reconciled with standard theoretical models. A so-called “peso problem” arises when investors anticipate a change in regime (possibly related to monetary policy) that is not realized over significant periods of time. This work investigates whether “peso problems” could produce a foreign currency risk premium that is far more persistent than predicted by standard models. These papers are antecedents of more recent asset-pricing research on the effects of disaster risk. The foreign exchange risk premium is also the focus of Chapter 4. Here, I present recent new research showing that variations in risk premia are empirically more important drivers of exchange-rate fluctuations than changes in interest rates. This empirical finding strongly contrasts with the predictions of traditional macromodels. The article then shows that risk premia can play this dominant role in exchange-rate determination in a model where investors’ preferences are subject to risk shocks.

Part II collects articles that study exchange-rate behavior from the microstructure perspective. Chapter 1 presents an empirical examination of high-frequency intra-day exchange-rate dynamics. This work shows that most intra-day fluctuations in exchange rates have nothing to do with the arrival of public news, which was the focus of traditional macro exchange-rate models. The remaining chapters in Part II present articles co-authored with Richard Lyons. These articles were the product of a long-standing collaboration that helped establish the microstructure approach to exchangerate modeling. Chapter 2 presents the working paper version of the article that first alerted many researchers to the potential of the microstructure approach. The paper presents a model of how the currency trading decisions of market participants link investors’ portfolio decisions to movements in the exchange rate, and how this link could be measured empirically using currency trading patterns. Chapter 3 extends this idea across multiple currency pairs. The chapters in Part II present articles that examine the links between exchange-rate fluctuations and currency trade in greater detail. Chapter 4 examines how the price impact of currency trades is affected by market conditions. Chapter 5, co-authored with Richard Lyons and Henry Cao, examines how information about foreign currency dealers’ inventory positions can be used to forecast future exchange-rate movements. Chapter 6 presents microstructure evidence supporting imperfect substitutability between different currency assets in international investors’ portfolios. The article then examines the implications of imperfect substitutability for the efficacy of sterilized foreign exchange intervention. As is well known, traditional macromodels are very poor at forecasting future changes in exchange rates. Chapters 7 and 9 show that microstructure models have superior forecasting power. The question of how news about macroeconomic conditions is transmitted to exchange rates via currency trading is addressed in Chapters 8 and 10.