Working Paper: NBER ID: w27199
Authors: Craig Burnside; Mario Cerrato; Zhekai Zhang
Abstract: This paper proposes a set of novel pricing factors for currency returns that are motivated by microstructure models. In so doing, we bring two strands of the exchange rate literature, namely market-microstructure and risk-based models, closer together. Our novel factors use order flow data to provide direct measures of buying and selling pressure related to carry trading and momentum strategies. We find that they appear to be good proxies for currency crash risk. Additionally, we show that the association between our order-flow factors and currency returns differs according to the customer segment of the foreign exchange market. In particular, it appears that financial customers are risk takers in the market, while non-financial customers serve as liquidity providers.
Keywords: Foreign Exchange; Order Flow; Risk Factor; Carry Trade; Momentum
JEL Codes: F31; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| carry-trade order flow factor (G15) | carry trade portfolio returns (G15) |
| increase in carry trade activity (G15) | increase in returns of high-interest rate currencies (F31) |
| decrease in carry trade activity (F32) | decrease in returns of high-interest rate currencies (F31) |
| financial customers' order flow (G29) | carry trade returns (G15) |
| non-financial customers' order flow (G29) | carry trade returns (G15) |
| type of customer (D16) | impact of order flow on currency returns (C69) |
| order flow (C69) | currency returns (F31) |