Discussion of Evans Discussion of Evans and Lyons, and Lyons, “A New Micro Model “A New Micro Model of Exchange Rate of Exchange Rate Dynamics” Dynamics”

Nelson C. MarkNelson C. Mark

University of Notre DameUniversity of Notre Dame

Description Description Bridging gap between two established Bridging gap between two established

areas of econ (microstructure and open areas of econ (microstructure and open macro) macro)

TOE (theory of everything)TOE (theory of everything) Unified (GE) theory of how price reveals Unified (GE) theory of how price reveals

private information in a customer-dealer and private information in a customer-dealer and inter dealer trading model with consumption inter dealer trading model with consumption and investment, and international trade under and investment, and international trade under incomplete markets. incomplete markets.

Main contributionsMain contributions Asks good questions. Bold research plan. An Asks good questions. Bold research plan. An

impressive piece of work that moves research impressive piece of work that moves research in a good direction. This is great.in a good direction. This is great.

Tells a tight and coherent story about price Tells a tight and coherent story about price discovery and information aggregation. i.e., discovery and information aggregation. i.e., How disparate and incomplete information on How disparate and incomplete information on fundamentals is conveyed through trading and fundamentals is conveyed through trading and incorporated into asset price. This is great.incorporated into asset price. This is great.

Price (exchange rate) deviates from Price (exchange rate) deviates from fundamentals over some fundamentals over some horizons/sampling intervals and is exactly horizons/sampling intervals and is exactly explained by fundamentals over other explained by fundamentals over other horizons/sampling intervals. This is great. horizons/sampling intervals. This is great.

Establishes theoretical foundations for Establishes theoretical foundations for concepts of order flow, hot potato trading, concepts of order flow, hot potato trading, inter dealer trading, etc. This is great. inter dealer trading, etc. This is great.

Microstructure Microstructure motivationmotivation

Reduced form demand-supply framework. Order flow Reduced form demand-supply framework. Order flow is buying or selling pressure.is buying or selling pressure.

Dealer holds inventory and sets bid-ask spread. Dealer holds inventory and sets bid-ask spread. Would like high volume, stable inventory. Adjust price Would like high volume, stable inventory. Adjust price to respond to order flowto respond to order flow

Order flow significant. High regression R-square Order flow significant. High regression R-square (around 0.6).(around 0.6).

S t=X t + S t-1+t

Microstructure Microstructure motivationmotivation

Question: What is the basis for order Question: What is the basis for order flow? flow?

Answer: Market participants place orders Answer: Market participants place orders based on private news about based on private news about fundamentals. fundamentals. This is Interesting to macroeconomistsThis is Interesting to macroeconomists

Subinterval Trading sequenceSubinterval Trading sequence

Given current state (wealth, partial revelation of Given current state (wealth, partial revelation of technology shocks, expected order flow) technology shocks, expected order flow) people post 2-way quotes on exchange rate.people post 2-way quotes on exchange rate.

Given prices, place and receive orders Given prices, place and receive orders (transactions). Realize intra period returns.(transactions). Realize intra period returns. Discover private information from observing order Discover private information from observing order

flow. flow. Everyone knows the information structure. Everyone knows the information structure.

Because I know your trading rule (and you know Because I know your trading rule (and you know mine), our actions (trade, order flow) reveals our mine), our actions (trade, order flow) reveals our private information. private information.

Main Results (Version 3)Main Results (Version 3)

Exchange rate fully explained by fundamentals Exchange rate fully explained by fundamentals when sampled at end of period. At other times, when sampled at end of period. At other times, fundamentals provide partial explanationfundamentals provide partial explanation

Raise Some IssuesRaise Some Issues Need to impose non negativity constraints on Need to impose non negativity constraints on

wealth, or show that they never bind in wealth, or show that they never bind in equilibrium. equilibrium.

Would like to see simulations of the model Would like to see simulations of the model where you can evaluate ex post unanticipated where you can evaluate ex post unanticipated order flow, and unanticipated goods demand order flow, and unanticipated goods demand (exports). (exports).

Would like to see simulations to assess ability Would like to see simulations to assess ability of model to match the volume of inter dealer of model to match the volume of inter dealer (hot potato) trading.(hot potato) trading.

Exchange Rate evolves, deviates Exchange Rate evolves, deviates from fundamentals, but is from fundamentals, but is insufficiently volatileinsufficiently volatile

Counterfactual model for Counterfactual model for capital returnscapital returns

Results in a further Results in a further reduction in volatilityreduction in volatility

Unclear how risk premia is relevant to Unclear how risk premia is relevant to exchange rateexchange rate

But risk premia are symmetric and net out. That is

ShortcomingsShortcomings

Solution is a projection onto limited information Solution is a projection onto limited information set which is less volatile than the full set which is less volatile than the full information set.information set.

Model can explain how price is imperfectly Model can explain how price is imperfectly explained by fundamentals but fundamentals explained by fundamentals but fundamentals gyrate around price, not the other way around.gyrate around price, not the other way around.

The model cannot explain (excess) volatility of The model cannot explain (excess) volatility of exchange rates. In fact, the exchange rate is exchange rates. In fact, the exchange rate is less volatile than the fundamentals.less volatile than the fundamentals.

ConcludeConclude

Impressive and provocative paper that Impressive and provocative paper that breaks new ground.breaks new ground.

Agree with Martin and Rich that this Agree with Martin and Rich that this should not be the last paper written on should not be the last paper written on the subject.the subject.