How Much You Know Matters: A Note on the Exchange Rate Disconnect Puzzle

Abstract:     
This paper offers a dynamic noisy rational expectations model of the foreign exchange market with two dimensions of information asymmetry. Some investors are assumed to have public information, the rest are assumed to possess both public and private information. This paper demonstrates why solutions to the widely documented exchange rate disconnect puzzle should take into account these dimensions of information asymmetry in the markets. It is shown in the model that as proportion of investors possessing only public information to those possessing both types of information changes, the disconnect between macroeconomic variables and the exchange rate reacts to changes in this proportion in important ways. A surprising finding is that this disconnect is bigger when the proportion of investors possessing more information about fundamentals in the market is smaller.

Number of Pages in PDF File: 21

Keywords: Market Microstructure, Foreign Exchange Market, Asymmetric Information

JEL Classification: F31, D82

working papers series