This paper addresses a fundamental trade-off in the design of multiple-dealer markets. Namely, though greater transparency can accelerate revelation of information in price, it can also impede dealer risk management. If dealers could choose the transparency regime ex ante, which regime would they choose? We show that dealers prefer incomplete transparency (meaning marketwide order flow is observed with noise). Slower price adjustment provides time for nondealers to trade, thereby sharing risk otherwise borne by dealers. At some point, however, further reduction in transparency impedes risk sharing: too noisy a public signal provides nondealers too little information to induce them to trade.Journal of Economic LiteratureClassification Numbers: F31, G15.

Data in this paper support both the inventory-control and asymmetric-information approaches to microstructure theory. Strong evidence of an inventory-control effect on price is new. The transactions dataset chronicles a trading week of a spot foreign exchange dealer whose daily volume averages over $1 billion. In addition to controlling inventory with his own price, the dealer also lays off inventory at other dealers' prices and through brokers. These results highlight the importance of inventory-control theory in understanding trading in this market.

Intraday interest rates are zero. Consequently, a foreign exchange dealer can short a vulnerable currency in the morning, close this position in the afternoon, and never face an interest cost. This tactic might seem especially attractive in times of fixed-rate crisis, since it suggests an immunity to the central bank's interest rate defense. In equilibrium, however, buyers of the vulnerable currency must be compensated on average with an intraday capital gain as long as no devaluation occurs. That is, currencies under attack should typically appreciate intraday. Using data on intraday exchange rate changes within the European Monetary System, we find this prediction is borne out.

We provide evidence of private information in the foreign exchange market. The evidence comes from the introduction of trading in Tokyo over the lunch hour. Lunch-return variance doubles with the introduction of trading, which cannot be due to public information since the flow of public information did not change with the trading rules. We then exploit microstructure theory to discriminate between the two alternatives: private information and mispricing. Four key results support the predictions of private-information models. Three of these involve changes in the intraday volatility U-shape. The fourth is that opening trade causes mispricing's share in variance to fall.

Macro news can affect currency prices directly and indirectly via order flow. Past research shows that the direct effects of scheduled macro news account for less than 10% of daily price variance. This paper shows that the arrival of macro news can account for more than 30% of daily price variance. Two features of our analysis account for this finding: (1) We consider the broad spectrum of macro news items that market participants observe, not just scheduled announcements. (2) We allow the arrival of news to affect prices indirectly via its impact on the volatility of order flow. Our analysis shows that order flow variations contribute more to currency price dynamics following the arrival of public macro news than at other times. This is not consistent with news effects being common knowledge that is impounded in price directly. Roughly two-thirds of the total effect of macro news on the DM/$ exchange rate is transmitted via order flow.

Intraday interest rates are zero. Consequently, a foreign exchange dealer can short a vulnerable currency in the morning, close this position in the afternoon, and never face an interest cost. This tactic might seem especially attractive in times of fixed‐rate crisis, since it suggests an immunity to the central bank's interest rate defense. In equilibrium, however, buyers of the vulnerable currency must be compensated on average with an intraday capital gain as long as no devaluation occurs. That is, currencies under attack should typically appreciate intraday. Using data on intraday exchange rate changes within the European Monetary System, we find this prediction is borne out.

Intraday interest rates are zero.Consequently, a foreign exchange dealer can short a vulnerable currency in the morning, close this position in the afternoon, and never face an interest cost.This tactic might seem especially attractive in times of crisis, since it suggests an immunity to the central bank's interest rate defense.In equilibrium, however, buyers of the vulnerable currency must be compensated on average with an intraday capital gain as long as no devaluation occurs.That is, currencies under attack should typically appreciate intraday.Using data on intraday exchange rate changes within the EMS, we find this prediction is borne out.

Meese-Rogoff Redux: Micro-Based Exchange-Rate Forecasting By MARTIN D . D . EVANS AND RICHARD K . LYONS* This paper compares the true, ex ante fore- casting performance of a micro-based model against both a standard macro model and a random walk. In contrast to existing literature, which is focused on longer-horizon forecasting, we examine forecasting over horizons from one day to one month (the one-month horizon being where micro and macro analysis begin to over- lap). Over our three-year forecasting sample, we find that the micro-based model consistently outperforms both the random walk and the macro model. Micro-based forecasts account for almost 16 percent of the sample variance in monthly spot rate changes. These results pro- vide a level of empirical validation as yet unat- tained by other models. The forecasting experiment proposed by Richard Meese and Kenneth Rogoff (1983) re- mains a benchmark against which exchange- rate models are judged. Their result that structural macro models cannot outperform a naive random walk has proved robust over the decades. Yet, the Meese-Rogoff paper was never about forecasting in the true sense (i.e., using tirrie-f information to forecast exchange rates at t + 1). B y using concurrent, realized values of the forcing variables, their regressions were more about concurrent explanation than about ex ante forecasting. Their only forecast- ing element is in their reliance on ex ante data to estimate equation parameters, which appro- priately penalized models whose estimated pa- rameters were unstable. tion for the random-walk nature of exchange rates is that there exists some unobserved fun- damental that itself follows a random walk (un- observed being important because fundamentals proposed in most macro models do not follow random walks). They offer a different explana- tion, one rooted in the asset approach to ex- change rates and the present-value relation that follows from it. Specifically, they show that i f fundamentals are 1(1), but not necessarily ran- dom walks, then as the discount factor in the present-value relation approaches 1, the ex- change rate will follow a process arbitrarily close to a random walk. Intuitively, given that an 1(1) process can be split into random-walk and stationary components, a discount factor near 1 means that most all of the weight is placed on fundamentals far into the future, ex- pectations of which are dominated by the random- walk component. Charles Engel and Kenneth West (2004, 2005) provide a valuable perspective on the forecastability of exchange rates. One explana- This paper takes the analysis of Engel and West as an important reorientation of thinking and brings it to the natural next step. Specifi- cally, if there is little room for forecasting based on stationary components of fundamentals, then one needs to focus on where all the action is, namely, exchange-rate dynamics that come from expectational surprises. Though the sur- prise part is, by definition, orthogonal to public information, our micro-based model shows that there should exist types of nonpublic infor- mation that are useful for forecasting this part, and where to look for these types of informa- tion. We then locate data on these types of nonpublic information and test whether they have true, ex ante forecasting power. We should * Evans: Department of Economics, Georgetown Uni- versity, Washington, DC 20057, and NBER; Lyons: Haas School of Business, University of California, Berkeley, C A 94720-1900, and NBER. We are grateful to Ken West for his comments and to the National Science Foundation for financial support. We refrain from using the word news because it has too strong an association with macro information that is public, which, even in the most careful of event studies, explains less than 5 percent of exchange-rate variation in total (see Torben Andersen et al., 2003).

This paper presents an exchange rate model of a new kind. Instead of relying exclusively on macroeconomic determinants, the model includes a determinant from the field of microstructure financeorder flow. Order flow is a determinant because it conveys information. This is a radically different approach to exchange rates. It is also strikingly successful. Our model of daily deutsche mark/dollar log changes produces an R2 statistic above 60 percent. For the deutsche mark/dollar spot market as a whole, we find that $1 billion of net dollar purchases increases the deutsche mark price of a dollar by 0.5 percent.