Working Paper: NBER ID: w7317
Authors: Martin D. D. Evans; Richard K. Lyons
Abstract: Macroeconomic models of nominal exchange rates perform poorly. In sample, R2 statistics as high as 10 percent are rare. Out of sample, these models are typically out-forecast by a na‹ve random walk. This paper presents a model of a new kind. Instead of relying exclusively on macroeconomic determinants, the model includes a determinant from the field of microstructure-order flow. Order flow is the proximate determinant of price in all microstructure models. This is a radically different approach to exchange rate determination. It is also strikingly successful in accounting for realized rates. Our model of daily exchange-rate changes produces R2 statistics above 50 percent. Out of sample, our model produces significantly better short-horizon forecasts than a random walk. For the DM/$ spot market as a whole, we find that $1 billion of net dollar purchases increases the DM price of a dollar by about 1 pfennig.
Keywords: order flow; exchange rates; microstructure; macroeconomics
JEL Codes: F31; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| order flow (C69) | exchange rates (F31) |
| billion-dollar net purchase (G19) | DM price of dollar (F31) |
| order flow (C69) | nominal exchange rates (F31) |
| order flow (C69) | daily changes in DM exchange rate (F31) |
| macroeconomic fundamentals (E66) | exchange rates (F31) |
| order flow (C69) | information not captured by macroeconomic models (E19) |