Stop-loss orders and price cascades in currency markets

Currency economists are puzzled by the great frequency of massive, abrupt exchange-rate changes. This paper provides evidence that such moves may be catalyzed by stop-loss orders, which create rapid, self-reinforcing price movements or "price cascades." The central hypothesis comes from theoretical finance research indicating that stop-loss trading can cause price discontinuities manifested as price cascades. Price cascades, which are inconsistent with standard structural exchange-rate models, may contribute to the "exchange-rate disconnect" problem. The paper also provides evidence that exchange rates respond to non-informative order flow. (c) 2005 Elsevier Ltd. All rights reserved.