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Order Flow and Exchange Rate Dynamics

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

Suggested Citation

  • Martin D. D. Evans and Richard K. Lyons., 1999. "Order Flow and Exchange Rate Dynamics," Research Program in Finance Working Papers RPF-288, University of California at Berkeley.
    • Handle: RePEc:ucb:calbrf:rpf-288
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    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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