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Order Flow and Exchange Rate Dynamics

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

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 naive 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.

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Paper provided by University of California at Berkeley in its series Research Program in Finance Working Papers with number RPF-288.

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Date of creation: 01 Aug 1999
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Handle: RePEc:ucb:calbrf:rpf-288
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