Working Paper: CEPR ID: DP4530
Authors: Paolo Vitale; Gabriele Dannunzio
Abstract: We propose a critical review of recent developments in exchange rate economics. This new strand of research is motivated by some very stark empirical evidence, relating exchange rate returns to order flow. Plenty of empirical evidence shows that order flow, i.e. the imbalance in the sequence of purchases and sales of foreign currencies in the markets for foreign exchange, is an extremely powerful determinant of short-run exchange rate movements. With a simplified analytical framework we see how, according to the rational expectation paradigm of asset pricing, such a relation reflects liquidity and information effects of portfolios shifts.
Keywords: exchange rate dynamics; foreign exchange microstructure; order flow
JEL Codes: D82; G14; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Positive order flow (C69) | appreciation of foreign currency (F31) |
| liquidity effects (E41) | spot rates (E43) |
| Order flow (C69) | short-run exchange rate movements (F31) |
| Order flow (C69) | exchange rates (F31) |
| Order flow (C69) | liquidity effects (E41) |