Stop-loss Orders and Price Cascades in Currency Markets

Currency economists are puzzled by the relatively high frequency of massive, abrupt exchange-rate changes, such as dollar-yen’s 11 percent decline on October 7, 1998. This paper provides evidence that such moves may be partly caused by stop-loss orders, which create rapid, self-reinforcing exchange rate movements or "price cascades." The central hypothesis, which is taken from prominent theoretical research in finance, suggests that positive feedback trading, of which stop-loss trading is an example, can cause discontinuities manifested as price cascades. The paper’s empirical analysis, which uses high-frequency exchange rates and order records from a major foreign exchange bank, indicates that stop-loss orders propagate trends and are sometimes triggered in waves, contributing to price cascades. Since price cascades are inconsistent with standard structural exchange rate models, they may be a factor behind the “exchange rate disconnect” problem. Stop-loss propagated price cascades could also be a mechanism through which exchange rates shift among multiple equilibria. Price cascades may help explain the well-known “fat tails” of the distribution of exchange-rate returns. The paper also provides evidence that exchange rates respond to noninformative order flow. (