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Order Flow and Exchange Rate Dynamics

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  • Martin D.D. Evans
  • Richard K. Lyons

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 na‹ve 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 1 pfennig.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7317.

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Date of creation: Aug 1999
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Publication status: published as Evans, Martin D. D. and Richard K. Lyons. "Order Flow And Exchange Rate Dynamics," Journal of Political Economy, 2002, v110(1,Feb), 170-180.
Handle: RePEc:nbr:nberwo:7317

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