Exchange Rate Determination and Forecasting: Can the Microstructure Approach Rescue Us from the Exchange Rate Disparity?

Using two measures of private information and high-frequency transaction data from the leading interdealer electronic broking system Reuters D2000-2, we examine the association between exchange rate return and contemporaneous order flow and the predictability power of lagged order flow on the future exchange rate return. Our empirical analysis demonstrates that at high frequency (5, 10, 15, 20, 25, and 30？min) there exists strong positive association between exchange rate returns and contemporaneous order flow. However, the results indicate weak predictability of order flow on the future exchange rate return. 1. Introduction In exchange rate economics one conventional common sense about exchange rates is that exchange rates follow a random walk process for frequencies less than annual, such as daily, weekly, or even monthly. However, exchange rates show some trend, cyclicality, or general history dependence at lower frequencies. In contrast to macroeconomic fundamental analysis at lower frequencies, studies on microstructure approaches to exchange rates focus on the movements in exchange rates at high frequency. In particular, microstructure approaches emphasize how exchange rates respond to order flow, which measures the net transaction pressure between buy and sell forces in the actual FX market. The theoretical frameworks for microstructure approaches to exchange rates have been sequentially built by Lyons [1] and Evans and Lyons [2]. In particular, the portfolio-shift model proposed by Evans and Lyons [2] is initially set up in a customer-dealer trading environment to show how order flow impacts exchange rates. Evans and Lyons apply the trading model to daily data obtained from the customer-dealer transaction platform Reuters D2000-1 to examine the exchange rate Deutsche mark/US dollar and Japanese yen/US dollar over May 1 to August 31, 1996. As a result, Evans and Lyons find that order flow can be a good series to determine the exchange rate movement at daily frequency. Similarly, empirical studies have applied this theoretical framework to various high-frequency data from diverse interdealer trading platforms. Killeen et al. [3] study the daily exchange rate German mark/French franc traded on the electronic broking system (EBS) in 1998. Hau et al. [4] study EBS data over 1998 to 1999 on the exchange rate German mark against US dollar. Berger et al. [5] study the intraday EBS data on the exchange rate US dollar/Japanese yen and Euro/US dollar spanning over January 1999 to February 2004. Ito and Hashimoto [6] study the intraday EBS data on the