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Monetary History, Exchange Rates and Financial Markets

Essays in Honour of Charles Goodhart, Volume Two

Edited by Paul Mizen

Monetary History, Exchange Rates and Financial Markets is an impressive collection of original papers in honour of Charles Goodhart’s outstanding contribution to monetary economics and policy. Charles Goodhart has written extensively on many of these topics and has become synonymous with his field; the chapters within this book offer a summary of current thinking on his own research subjects and include perspectives on controversies surrounding them.
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Chapter 6: Customer trades and extreme events in foreign exchange

Mintao Fan and Richard K. Lyons


Mintao Fan and Richard K. Lyons* 1. INTRODUCTION Professor Goodhart’s impact has been substantial in many areas. One of those areas is a growing field that uses tools from microstructure finance to analyse exchange-rate behaviour (the ‘microstructure approach’ to exchange rates). This chapter is an introduction to one of the frontiers of that field. It addresses the trading of FX customers: investors, importers, exporters, corporate Treasurers, and so on. Past work within the microstructure approach has focused on FX trading between banks, or ‘interdealer’ trading. It is true that most of the trading in FX is interdealer. Nevertheless, interdealer trading is in a sense derivative: it is the demands of non-dealer customers that represent underlying demand for currencies in the real economy. Data necessary for this analysis have become available only recently, in part due to the wholesale shift to electronic trading (and the data capture it permits). Our main results include the following. First, we find that aggregate customer order flow in our sample (10–15 per cent of the market-wide total) shows little evidence of mean reversion.1 Indeed, customer order flow cumulated over time is approximately a random walk. Second, aggregate customer order flow tracks exchange rate movements at lower frequencies (for example annual) rather closely. Third, when aggregate customer order flow is disaggregated, we find that the parts behave rather differently. For example, our case study on the 10 per cent drop in the yen/$ rate that occurred in a single day in 1998 (around the...

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