Do Currency Markets Absorb News Quickly?

This paper addresses an important null hypothesis within exchange-rate theory: that
macro news is impounded in exchange rates instantaneously. This is typically understood to mean
a matter of seconds, or perhaps minutes (e.g., 5 to 10), but certainly contained within the day of
news arrival. We test this by examining the effects of news on subsequent currency trades by enduser
participants (such as hedge funds, mutual funds, and non-financial corporations). We find
that news arrivals induce subsequent changes in trading behavior in all of these major end-user
segments. These induced changes in trading remain significant for days. Induced trades also have
persistent effects on prices. These findings provide strong evidence that currency markets are not
responding to news instantaneously.
Our basis for pursuing whether induced trades might prolong the absorption of news
comes from recent empirical work demonstrating a tight link between signed transaction volume
(order flow) and signed exchange rate changes.1 This link is not predicted by macro exchange rate
theory, but it is predicted by an alternative modeling framework from microstructure finance. In
this micro-based framework, transactions play a central, causal role in price determination (see,
e.g., Glosten and Milgrom 1985, Kyle 1985). The causal role arises because transactions convey
information that is not common knowledge. In this paper, we address whether the tight link
between price adjustment and order flow that exists in general might also be playing a role in how
currency markets absorb news.
Most of the existing literature linking exchange rates to news is event-study based, and
does not address how transaction quantities respond to news (i.e., it addresses the link between
news and price in isolation). This literature has two branches. The first addresses the direction of
exchange-rate changes (first moments) and the second, later branch addresses exchange-rate
volatility (second moments). A common finding of the first branch is that, at least at the daily
frequency, directional effects from scheduled macro announcements are difficult to detect
because they are swamped by other factors affecting price. Intraday event studies do find
statistically significant effects, particularly for employment and money-supply announcements