Order flow and exchange rate dynamics in electronic brokerage system data

We analyze the association between order flow and exchange rates using a new dataset representing a majority of global interdealer transactions in the two most-traded currency pairs at the one minute frequency over a six-year time period. This long span of high-frequency data allows us to gain new insights about the joint behavior of these series. We first confirm the presence of a substantial association between interdealer order flow and exchange rate returns at horizons ranging from 1 min to two weeks, but find that the association is substantially weaker at longer horizons. We study the time-variation of the association between exchange rate returns and order flow both intradaily and over the long term, and show that the relationship appears to be stronger when market liquidity is lower. Overall, our study supports the view that liquidity effects play an important role in the relationship between order flow and exchange rate changes. This by no means rules out a role for order flow as a channel by which fundamental information is transmitted to the market, as we show that our findings are quite consistent with a recent model by Bacchetta and Van Wincoop (2006: Can information heterogeneity explain the exchange rate determination puzzle? American Economic Review, 96, pp. 552-576.) that combines both liquidity and information effects.