Working Paper: CEPR ID: DP4806
Authors: Peter Dunne; Harald Hau; Michael Moore
Abstract: Macroeconomic models of equity returns perform poorly. The proportion of daily index returns that these models explain is essentially zero. Instead of relying on macroeconomic determinants, our model includes a concept from microstructure order flow. Order flow is the proximate determinant of price in all microstructure models. We explain aggregate equity returns as well as exchange rates in a model with heterogenous beliefs. Belief changes are shown to be observable through order flow. To test the model we construct daily aggregate order flow data from all equity trades in the U.S. and France from 1999 to 2003. Almost 60% of the daily returns in the S&P100 index are explained jointly by exchange rate returns and macroeconomic order flows.
Keywords: equities; exchange rates; international macroeconomics; microstructure
JEL Codes: F30; F31; G10; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Changes in investor beliefs (G40) | Order flows (C69) |
| Order flows (C69) | Equity returns (G12) |
| Changes in investor beliefs (G40) | Equity returns (G12) |
| Order flows (C69) | Foreign exchange returns (F31) |
| Foreign exchange returns (F31) | Equity returns (G12) |