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An Empirical Study of Liquidity and Information Effects of Order Flow on Exchange Rates
Francis Breedon (Tanaka Business School, Imperial College London)Paolo Vitale (Università D’Annunzio and CEPR)
FEATURED IN PROFESSIONAL INVESTOR
Abstract
Order flow based models seem to offer a promising route to understanding the dynamics of exchange rates. Certainly, R²s of nearly 70% as we have found here are likely to dazzle even the most estimation-weary exchange rate economist. Nevertheless, disentangling the information and liquidity effects that may underlie the explanatory power of order flow is a challenging task. With respect to previous studies based on the analysis of reduced form models we propose an improvement in that our analysis is based on the estimation of a structural model of exchange rate determination.
While a first look at the correlations between order flow, exchange rate returns and innovations in the interest rate differential can suggest an information-based interpretation of the effect of trade innovations on the exchange rate, our investigation indicates that order flow explains very little in terms of information or fundamentals. The relationship between order flow and exchange rates seems to be almost totally due to liquidity effects and not to any information contained in order flow.
To read the paper, click HERE.
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