Noisy Information and Expectation Formation in the Foreign Exchange Market

Market microstructure and the imperfect common knowledge literature in macroeconomics both analyze the effect of dispersed information on prices. This paper draws on both sources to understand exchange rate forecasting errors. A theoretical model is developed showing that forecasting errors depend on both forecast revisions as in the Woodford noisy information model and order flow as in the Evans-Lyons simultaneous trade model. This is applied to Brazilian data using a unique data set of daily consensus exchange rate forecasts managed by the Banco Central do Brasil along with order flow derived from the FX futures market. The results strongly support the theory