Order Flow and Exchange Rate Dynamics

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 exchangerate 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.