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.

Segmentation and time-of-day patterns in foreign exchange markets

“…Thus, liquidity suppliers can 10 There is a new strand of literature in which the microstructure of foreign exchange markets is modelled, e.g. Evens and Lyons (2002aLyons ( , 2002b and Lyons (2001). These models typically focus on the dealer's behaviour while, in our setting, the distinction between liquidity supplier and demander as well as the final investor play an essential role.…”

“…In turn, this market condition should strengthen liquidity traders' inventory imbalance and risk. If this 17 By meteorological analogy, Engle, Ito and Lin (1990) refer to a meteor shower for a situation in which volatility spreads across regions in chronological order ("it rains down on the earth as it turns") whereas the term heat wave refers to volatility transmission specific to one locality ("a hot day in New York is likely to be followed by another hot day in New York"). 18 Bessembinder (1994) analyses patterns in exchange rate volatility, trading volume and spreads before holidays.…”

Order book approach to price impact

“…prices go up if demand exceeds supply and go down if supply exceeds demand. The analysis of huge financial data sets [1] allows a detailed study of the price impact function [2][3][4][5][6][7][8][9][10][11][12], which quantifies the relation between order imbalance and price changes.…”

“…In previous studies [1][2][3][4][5][6][7][8][9][10]12] (with the exception of [11]), the price impact of trades was calculated by determining whether a given trade was buyer or seller initiated [13]. Here, we analyze order book data which unambiguously allow to identify the character of a transaction.…”

Event-Driven Business Intelligence Approach for Real-Time Integration of Technical and Fundamental Analysis in Forex Market

“…Several researches showed the impact of order flow (Berger et al, 2006;Evans and Lyons, 2002b;, news arrivals and macroeconomics announcements (Almeida et al, 1998;Andersen and Bollerslev, 2003;Chang and Taylor, 2003;Evans and Lyons, 2002a; and fundamentals (Evans and Lyons, 2002b; on forex trading process and the market status.…”