Order Flow and Exchange Rate Dynamics

Martin Evans and Richard K. Lyons

Research Program in Finance, Working Paper Series from Research Program in Finance, Institute for Business and Economic Research, UC Berkeley

Abstract: Macroeconomic models of nominal exchange rates perform poorly. In sample, R 2 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 R 2 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 1 pfennig.

Keywords: Order Flow; Exchange Rate; Microstructure; Fundamentals; and Forecasting (search for similar items in EconPapers)
Date: 1999-08-01
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Citations: View citations in EconPapers (70)

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Working Paper: Order Flow and Exchange Rate Dynamics (1999)
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