Working Paper: CEPR ID: DP7225
Authors: Dagfinn Rime; Lucio Sarno; Elvira Sojli
Abstract: This paper adds to the research efforts that aim to bridge the divide between macro and micro approaches to exchange rate economics by examining the linkages between exchange rate movements, order flow and expectations of macroeconomic variables. The basic hypothesis tested is that if order flow reflects heterogeneous expectations about macroeconomic fundamentals, and currency markets learn about the state of the economy gradually, then order flow can have both explanatory and forecasting power for exchange rates. Using one year of high frequency data collected via a live feed from Reuters for three major exchange rates, we find that: i) order flow is intimately related to a broad set of current and expected macroeconomic fundamentals; ii) more importantly, order flow is a powerful predictor of daily movements in exchange rates in an out-of-sample exercise, on the basis of economic value criteria such as Sharpe ratios and performance fees implied by utility calculations.
Keywords: exchange rates; forecasting; macroeconomic news; microstructure; order flow
JEL Codes: F31; F41; G10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| macroeconomic fundamentals (E66) | order flow (C69) |
| order flow (C69) | exchange rates (F31) |
| macroeconomic fundamentals (E66) | exchange rates (F31) |