Faculty Publication by Carol Osler

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Faculty Member:

Carol Osler

Title of Publication:

"Short-Run Exchange-Rate Dynamics: Theory, and Evidence"

Publication Type:

Working Paper

Year of Publication:

2005

Co-Authors:

John A. Carlson, Carol L. Osler

Abstract:

Research in currency market microstructure has by now revealed a wealth of information about the relationship between currency trading and exchange rates. This paper develops a model of short-run exchange-rate dynamics consistent with these observations, and applies it to the forward premium puzzle. Despite the newness of the evidence, the underlying structure of the model is not new. Indeed, over the past two decades a number of authors have independently developed models based on the same underlying structure (e.g. Black 1985, Driskill and McCafferty 1980a, 1980b, 1982, 1992, Driskill, Mark, and Sheffrin 1987, Osler 1995, 1998, Carlson and Osler 2000, Hau and Rey 2004, Sager and Taylor 2005a). Using calibrated simulations we show that the model's predicted short-run exchange-rate behavior fits all the stylized facts associated with the forward premium puzzle. The model implies a linear equation governing short-run exchange rate dynamics. Regressions based on this linear equation, using quarterly data for five currency-pairs, strongly support the model. In addition to their broad support for this microstructure-based model, these regression results suggest that microstructure may be relevant to exchange-rate dynamics at macro horizons. [JEL classifications: F31, G12, G15]

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