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

1. Discussion of Evans and Lyons, “A New Micro Model of Exchange Rate Dynamics” Nelson C. Mark University of Notre Dame

2. Description • Bridging gap between two established areas of econ (microstructure and open macro) • TOE (theory of everything) • Unified (GE) theory of how price reveals private information in a customer-dealer and inter dealer trading model with consumption and investment, and international trade under incomplete markets.

3. Main contributions • Asks good questions. Bold research plan. An impressive piece of work that moves research in a good direction. This is great. • Tells a tight and coherent story about price discovery and information aggregation. i.e., How disparate and incomplete information on fundamentals is conveyed through trading and incorporated into asset price. This is great.

4. Price (exchange rate) deviates from fundamentals over some horizons/sampling intervals and is exactly explained by fundamentals over other horizons/sampling intervals. This is great. • Establishes theoretical foundations for concepts of order flow, hot potato trading, inter dealer trading, etc. This is great.

5. Microstructure motivation • Reduced form demand-supply framework. Order flow is buying or selling pressure. • Dealer holds inventory and sets bid-ask spread. Would like high volume, stable inventory. Adjust price to respond to order flow • Order flow significant. High regression R-square (around 0.6).

6. Microstructure motivation • Question: What is the basis for order flow? • Answer: Market participants place orders based on private news about fundamentals. • This is Interesting to macroeconomists

7. Subinterval Trading sequence Given current state (wealth, partial revelation of technology shocks, expected order flow) people post 2-way quotes on exchange rate. • Given prices, place and receive orders (transactions). Realize intra period returns. • Discover private information from observing order flow. • Everyone knows the information structure. Because I know your trading rule (and you know mine), our actions (trade, order flow) reveals our private information.

8. Main Results (Version 3) • Exchange rate fully explained by fundamentals when sampled at end of period. At other times, fundamentals provide partial explanation

9. Raise Some Issues • Need to impose non negativity constraints on wealth, or show that they never bind in equilibrium. • Would like to see simulations of the model where you can evaluate ex post unanticipated order flow, and unanticipated goods demand (exports). • Would like to see simulations to assess ability of model to match the volume of inter dealer (hot potato) trading.

10. Exchange Rate evolves, deviates from fundamentals, but is insufficiently volatile

11. Counterfactual model for capital returns

12. Results in a further reduction in volatility

13. Unclear how risk premia is relevant to exchange rate But risk premia are symmetric and net out. That is

14. Shortcomings • Solution is a projection onto limited information set which is less volatile than the full information set. • Model can explain how price is imperfectly explained by fundamentals but fundamentals gyrate around price, not the other way around. • The model cannot explain (excess) volatility of exchange rates. In fact, the exchange rate is less volatile than the fundamentals.

15. Conclude • Impressive and provocative paper that breaks new ground. • Agree with Martin and Rich that this should not be the last paper written on the subject.