A New Micro Model of Exchange Rate Dynamics

We address the exchange rate determination puzzle by examining how information is aggregated in a dynamic general equilibrium (DGE) setting. Unlike other DGE macro models, which enrich either preference structures or production structures, our model enriches the information structure. The model departs from microstructure-style modeling by identifying the real activities where dispersed information originates, as well as the technology by which information is subsequently aggregated and impounded. Results relevant to the determination puzzle include: (1) persistent gaps between exchange rates and macro fundamentals, (2) excess volatility relative to macro fundamentals, (3) exchange rate movements without macro news, (4) little or no exchange rate movement when macro news occurs, and (5) a structural-economic rationale for why transaction flows perform well in accounting for monthly exchange rate changes, whereas macro variables perform poorly. Though past micro analysis has made progress on results (1) through (3), results (4) and (5) are new. Excess volatility arises in our model for a new reason: rational exchange rate errors feed back into the fundamentals that the exchange rate is trying to track.

Do Currency Markets Absorb News Quickly?

This paper addresses whether macro news arrivals affect currency markets over time. The null from macro exchange-rate theory is that they do not: macro news is impounded in ex-change rates instantaneously. We test this by examining the effects of news on subsequent trades by end-user participants (such as hedge funds, mutual funds, and non-financial corporations). News arrivals induce subsequent changes in trading in all of the major end-user segments. These induced changes remain significant for days. Induced trades also have persistent effects on prices. Currency markets are not responding to news instantaneously.

Informational Integration and FX Trading

This paper addresses international financial integration in a new way. We focus on informational integration, specifically, the importance of information conveyed by order flow in major currencies for pricing minor currencies. We develop a multi-currency model of portfolio allocation in the presence of dispersed information. We then test the modelÂ’s implications using four months of concurrent transaction data on nine currencies. The model explains 45 to 78 percent of daily returns in all nine currencies. Moreover, its prediction that order flow in individual markets should be relevant for determining prices in other markets is borne out.Exchange Rates, Order flow, Financial Integration

Order Flow and Exchange Rate Dynamics

Macroeconomic models of nominal exchange rates perform poorly. In sample, R2 statistics as high as 10 percent are rare. Out of sample, these models are typically out-forecast by a na‹ve random walk. This paper presents a model of a new kind. Instead of relying exclusively on macroeconomic determinants, the model includes a determinant from the field of microstructure-order flow. Order flow is the proximate determinant of price in all microstructure models. This is a radically different approach to exchange rate determination. It is also strikingly successful in accounting for realized rates. Our model of daily exchange-rate changes produces R2 statistics above 50 percent. Out of sample, our model produces significantly better short-horizon forecasts than a random walk. For the DM/$spot market as a whole, we find that$1 billion of net dollar purchases increases the DM price of a dollar by about 1 pfennig.

Are Different-Currency Assets Imperfect Substitutes?

This paper provides a new test for whether different-currency assets are imperfect substitutes. The test exploits that under floating rates, changing public currency demand has no direct effect on monetary fundamentals, current or future. Price effects from imperfect substitutability are clearly present: the immediate price impact of public trades is 0.44 percent per 1 billion dollar (of which, about 80 percent persists indefinitely). This estimate is applicable to intervention trades in the special case when they are indistinguishable from private trades (i.e., when interventions are sterilized, anonymous, and provide no monetary-policy signal).

Portfolio Balance, Price Impact, and Secret Intervention

This paper tests the portfolio-balance approach to exchange rate determination in a new way. Past work on portfolio balance in foreign exchange falls into two groups: (1) tests using measures of asset supply and (2) tests using measures of central-bank asset demand. We address the demand side, but we use a broad measure of public demand, rather than focusing on demand by central banks. Under floating rates, changing public demand has no direct effect on interest rates, current or future. This provides an opportunity to test for portfolio-balance effects on price. We develop and estimate a micro portfolio-balance model that has both Walrasian and microstructure features. Portfolio-balance effects are clearly present: the immediate price impact of public trades is 0.44 percent per $1 billion (of which, about 80 percent persists indefinitely). This estimate is applicable to central-bank trades as well, as long as they are sterilized, secret, and provide no monetary-policy signal. Intervention of this type is most effective when the flow of macroeconomic news is strong.

Are Different-Currency Assets Imperfect Substitutes?

This paper provides a new test for whether different-currency assets are imperfect substitutes. Past work on imperfect substitutability in foreign exchange falls into two groups: (1) tests using measures of asset supply and (2) tests using measures of central-bank asset demand. We address the demand side, but we use a broad measure of public demand rather than focusing on demand by central banks. Under floating rates, changing public demand has no direct effect on monetary fundamentals, current or future. This provides an opportunity to test for price effects from imperfect substitutability. We develop and estimate a micro portfolio balance model that has both Walrasian and microstructure features. Price effects from imperfect substitutability are clearly present: the immediate price impact of public trades is 0.44 percent per $1 billion (of which, about 80 percent persists indefinitely). This estimate is applicable to intervention trades in the special case when they are indistinguishable from private trades (i.e., when interventions are sterilized, anonymous, and provide no monetary-policy signal).

Exchange Rate Fundamentals and Order Flow

We address whether transaction flows in foreign exchange markets convey fundamental information. Our GE model includes fundamental information that first manifests at the micro level and is not symmetrically observed by all agents. This produces foreign exchange transactions that play a central role in information aggregation, providing testable links between transaction flows, exchange rates, and future fundamentals. We test these links using data on all end-user currency trades received at Citibank over 6.5 years, a sample sufficiently long to analyze real-time forecasts at the quarterly horizon. The predictions are borne out in four empirical findings that define this paper's main contribution: (1) transaction flows forecast future macro variables such as output growth, money growth, and inflation, (2) transaction flows forecast these macro variables significantly better than the exchange rate does, (3) transaction flows (proprietary) forecast future exchange rates, and (4) the forecasted part of fundamentals is better at explaining exchange rates than standard measured fundamentals.

Inventory Information

In a market with symmetric information about fundamentals, can information-based trade still arise? Consider bond and FX markets, where private information about nominal cash flows is generally absent, but participants are convinced that superior information exists. We analyze a class of asymmetric information - inventory information - that is unrelated to fundamentals, but still forecasts future price (by forecasting future discount factors). Empirical work based on the analysis shows that inventory information in FX does indeed forecast discount factors, and does so over both short and long horizons. The immediate price impact of shocks to inventory information is large, roughly 50 percent of that from public information shocks (the latter being the whole story under symmetric information). Within about 30 minutes the transitory effect dies out, and prices reflect a permanent effect from inventory information that ranges between 15 and 30 percent of that from public information.

The electronic Hamiltonian for cuprates

A realistic many-body Hamiltonian for the cuprate superconductors should include both copper d and oxygen p states, hopping matrix elements between them, and Coulomb energies, both on-site and inter-site. We have developed a novel computational scheme for deriving the relevant parameters ab initio from a constrained occupation local density functional. The scheme includes numerical calculation of appropriate Wannier functions for the copper and oxygen states. Explicit parameter values are given for La2CuO4. These parameters are generally consistent with other estimates and with the observed superexchange energy. Secondly, we address whether this complicated multi-band Hamiltonian can be reduced to a simpler one with fewer basis states per unit cell. We propose a mapping onto a new two-band effective Hamiltonian with one copper d and one oxygen p derived state per unit cell. This mapping takes into account the large oxygen-oxygen hopping given by the ab initio calculations