Microstructure order flow: statistical and economic evaluation of nonlinear forecasts

Abstract

In this paper we propose a novel empirical extension of the standard market microstructure order ‡ow model. The main idea is that heterogeneity of beliefs in the foreign exchange market can cause model instability and such instability has not been fully accounted for in the existing empirical literature. We investigate this issue using two di¤erent data sets and focusing on out-of-sample forecasts. Forecasting power is measured using standard statistical tests and, additionally, using an alternative approach based on measuring the economic value of forecasts after building a portfolio of assets. We …nd there is a substantial economic value on conditioning on the proposed models.JEL Classi…cation:F31; F41; G10

Foreign Exchange Order Flow as a Risk Factor

“…2 See, among others, Evans and Lyons (2002), Cerrato et al (2011), Evans (2011), Evans and Rime (2012), Cerrato et al (2015), Breedon et al (2016), and Menkhoff et al (2016).…”

“…Burnside (2012) suggests that a significant part of trading activity in foreign exchange markets is triggered by carry trade investors Breedon et al (2016). show that there is a strong relationship between order flow data and currency forward premia.14 SeeCerrato et al (2015) andMenkhoff et al (2016).…”

Foreign Exchange Order Flow as a Risk Factor

“…Burnside (2012) suggests that a significant part of trading activity in foreign exchange markets is triggered by carry trade investors Breedon et al (2016). show that there is a strong relationship between order flow data and currency forward premia.19 SeeCerrato et al (2015) andMenkhoff et al (2016).…”