Explaining Trading Volume in Foreign Exchange: The three approaches

The three approaches

Until the 1970s the goods market approach was the traditional explanation for exchange rate movements. Under this approach, demand for currencies is determined largely by purchases and sales of goods. For example, an increase in exports increases foreigners' demand for domestic currency to pay for those exports. The FX trading volume this approach produces, however, is limited to the underlying volume of trade in real goods and services. This is grossly inconsistent with the data: trade in goods and services can account for less than 5% of FX trading.

In the 1970s the asset market approach emerged. It built on the earlier approach by recognizing that the demand for currencies depends not only on purchases and sales of goods, but also on purchases and sales of assets. For example, in order to purchase a Japanese government bond an investor must first purchase the yen needed to make payment. While the asset market approach clarified thinking considerably, empirical work in the 1980s could not confirm it: the macroeconomic variables that move exchange rates under this approach do not have the predicted effect. Moreover, this approach does not explain the enormity of the trading volume. The reason is that, under this approach, macroeconomic information relevant for purchasing and selling assets is publicly available, and everybody agrees on the implications of that information. In this setting, news moves the exchange rate without trading. And people do not trade with one another on the basis of different views because they all hold the same view. Thus, seen from this approach, the enormous trading volume in FX remains a puzzle.

Analyzing the Tokyo experiment--the lifting of the lunchtime trading restriction--illustrates a new approach to exchange rates, the microstructure approach. Like the asset market approach, this approach focuses on the demand for currencies as coming from purchases and sales of assets. It extends the asset market approach by loosening three of its most uncomfortable assumptions. First, microstructure models relax the assumption that all information relevant to exchange rates is publicly available. For example, bank traders, at their trading desks see trades and quotes in the market that are not observable by the public. These quotes and trades may be valuable for forecasting future exchange rate movements, even if only in the short run (e.g., seeing a central bank's intervention trade before the rest of the market). Second, the microstructure models loosen the assumption that all market participants are alike. For example, traders may disagree about the implications of a given piece of information; or they may be trading for different reasons-like hedging versus speculation. Third, this approach models the trading environment more explicitly. For example, microstructure models are explicit about the timing of trades--o