Private information, stock markets, and exchange rates

Abstract:

Explaining exchange rates has long been an important but vexing issue in international economics and finance. In recent years, a number of studies have shown that investors' private information plays a central role in determining exchange rates. We demonstrate in this paper that the private information of investors relevant for exchange rates is largely connected to the stock market, and that this information is conveyed to foreign exchange (FX) markets by order flow that is induced by investors' transactions in the stock market. We establish these results by analyzing several novel unused datasets on nearly two years' worth of daily-frequency capital flows of nonresident investors in the foreign exchange, stock, and bond markets of Thailand. We present compelling evidence that FX order flow that is induced by nonresident investors transactions in the Stock Exchange of Thailand - which we show are driven largely by private information - has far greater explanatory power for the exchange rate than other order flow has, both in the short run and the long run. In contrast, FX order flow of nonresident investors that is related to their transactions in Thai government bonds - which we find are not driven appreciably by private information - does not have a statistically significant effect on the exchange rate.

JEL Classification Numbers: C22, E58, F31, F37, G14

Keywords: Exchange rate models, market microstructure approach, asymmetric information, Thailand, generated regressors, impulse response functions, I(1) measurement error