Order Flow and Exchange Rate Dynamics

Martin Evans and David Lyons ()
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Martin Evans and David Lyons: Department of Economics, Georgetown University, http://www9.georgetown.edu/faculty/evansm1/

Working Papers from Georgetown University, Department of Economics

Abstract: Macroeconomic models of nominal exchange rates perform poorly. In sample, R2 statistics as high as 10 percent are rare. Out of sample, these models are typically out-forecast by a naïve random walk. This paper presents a model of a new kind. Instead of relying exclusively on macroeconomic determinants, the model includes a determinant from the field of microstructure--order flow. Order flow is the proximate determinant of price in all microstructure models. This is a radically different approach to exchange rate determination. It is also strikingly successful in accounting for realized rates. Our model of daily exchange-rate changes produces R2 statistics above 50 percent. Out of sample, our model produces significantly better short-horizon forecasts than a random walk. For the DM/$ spot market as a whole, we find that $1 billion of net dollar purchases increases the DM price of a dollar by about 0.5 percent.

Date: 2001-01-11
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