Fundamentals and risk in currency markets: The role of microstructure principles and parameter instability

This dissertation asks if exchange rates are related to macroeconomic fundamentals and risk. Despite the well-founded rationale for believing they should be, the poor empirical record of fundamentals and risk-based exchange rate models is well documented. The evidence provided herein suggests that yes, fundamentals and risk do matter. To provide this evidence, I take direction from recent strands of the literature that trace the troubles of standard models back to their underlying assumptions. In particular, I show that in order to find a significant relationship between exchange rates and fundamentals, one must allow for change in the process relating the causal variables to the outcomes. While there may be many candidate reasons for structural change, the focus here is on revisions in how participants forecast future outcomes. An important question then becomes how to model these revisions. I find evidence for change that follows both discrete breaks, as well as a smoother nofcnlinear process. In addition, I incorporate findings from the foreign exchange microstructure literature, which directs researchers to consider that the institutional details of currency markets are important factors if one wants to understand exchange rates. More specifically, transaction order flow is found to be an important intermediary between fundamentals and exchange rates. The lesson is that previous attempts at finding a connection were unsuccessful in part because they omitted both concerns for structural change and for microstructure principles. I also show that risk is an important consideration for our understanding of currency returns. Instead of second-moment measures, which are responsible for noted empirical troubles, I instead test a measure of risk based on deviations of the exchange rate from its benchmark value. This conception of risk takes into account that swings in exchange rates are an inherent part of the casual process, and allows participants to internalize this when consider the potential for loss when speculating.