Order Flow and Exchange Rate Dynamics

Abstract

This paper presents an exchange rate model of a new kind. Instead of relying exclusively on macroeconomic determinants, the model includes a determinant from the field of microstructure finance—order flow. Order flow is a determinant because it conveys information. This is a radically different approach to exchange rates. It is also strikingly successful. Our model of daily deutsche mark/dollar log changes produces an R 2 statistic above 60 percent. For the deutsche mark/dollar spot market as a whole, we find that $1 billion of net dollar purchases increases the deutsche mark price of a dollar by 0.5 percent.