Exchange Rate Economics: Theories and Evidence

366 Market microstructure approach
the latter accounts for the majority of order flow’s impact effect,and this is seen as
resurrecting the portfolio-balance approach. They also show that trades have the
most price impact when the flow of macroeconomic news is strong. This is also
shown to apply to intervention trades as well,as long as they are sterilised,secret
and provide no policy signal.
In an attempt to understand if it is information flows – and particularly the
split between private and public information – that drive order flow,Evans and
Lyons (2003) analyse the effect of macroeconomic news on order flow (which is
distinct from the question of whether volume is determined by news). The effect
of news on exchange rates is considered in Chapter 15. The Evans and Lyons
paper differs from that body of work by considering a broader set of macro-news
and by using an approach based on state-dependent heteroscedasticty,rather than
an event-study approach. This approach follows Rigobon and Saack (2003) and
involves using generalised method of moments (GMM) to identify the relative
importance of the direct and indirect effects from news by allowing the variances
of shocks to order flow and price to depend separately on the rate of news. The
basic hypothesis in the paper is that news affects exchange rates through order
flow because market participants draw different inferences (i.e. are heterogeneous)
from common macro-data. Both daily and intra-daily data on the exchange rate
change and order flow are drawn from the Reuters D2000–1 dealing system for
the DM–USD over the period 1 May–31 August 1996. As we have seen,this data
is time-stamped tick-by-tick data and involves a full 24-hour trading day. The data
on news is extracted from the Reuter’s Money Market Headline News screen.
The model of Evans and Lyons (2003) allows for three sources of exchange
rate variation. The first is the standard effect of public news,as captured by the
models in Chapters 4 and 5,in which news impacts onto price immediately and
directly,with no role for order flow. The second source is the indirect effect of
news operating on the price via order flow,while the third source of exchange
rate variation is due to order flow unrelated to news arrival. Evans and Lyons
find that while all three sources of price variation are statistically significant but
that two-thirds of the price effect from macro-news comes via order flow while the
remaining third comes from the standard direct effect. They also report evidence
which is indicative of uni-directional causality between news and exchange rates.
Cao et al. (2003) set about answering the following question: in a market,such as
the foreign exchange market,with symmetric information about fundamentals,can
information-based trade still arise? In particular,in such a market does inventory
information impact on price? Their answer to this question is a resounding ‘yes’.
Their analysis clarifies that price effects arising from non-fundamentals trades are
of three types: a transitory,idiosynchratic,effect which is the so-called inventory
effect from microstructure theory; a transitory effect common to all market makers;
and a permanent effect which is common to all traders. Using the intra-daily
data from the Reuters D2000–1 dealing system for the DM–USD they show that
inventory information has both transitory and permanent price effects. In particular,a
$1 billion positive shock to inter-dealer order flow permanently increases the
DM–USD by 0.25 to 0.45 of a pfenning. These permanent effects are also shown