Herding the Scapegoats: Foreign Exchange Order Flow and the Time-Varying Effect of Fundamentals

45 Pages Posted: 29 May 2014 Last revised: 4 Jun 2014

See all articles by Anna Lindahl

Anna Lindahl

Stockholm School of Economics - Department of Finance

Michael Moore

University of Warwick - Warwick Business School

Dagfinn Rime

BI Norwegian Business School

Ali Shehadeh

Queen's University Belfast - Finance

Date Written: March 21, 2014

Abstract

The poor performance of macroeconomic exchange rate models in and out-of-sample is well documented in literature. One reason for this result is the impact of ‘scapegoat’ effects: that is, participants attach different weights to different macro fundamentals in different periods. On the other hand, microstructure approaches to exchange rate determination demonstrate the importance of order flow to both explain and forecast exchange rates. Monthly data sets for order flow on the three currency pairs $/€, ¥/$ and SEK/€ along with their macro ‘fundamentals’ are used to explore this puzzle. We find evidence supporting scapegoat effects that (i) the instability in the return-fundamentals relation is matched by a similar instability in the relation between order flow and fundamentals; and (ii) the predicted order flow from the time-varying relation with fundamentals (macro-induced order flow) has strong explanatory power for spot returns. We conclude that the consistent and more stable impact of order flow, in part, comes from the fact that it absorbs and acts as a sufficient statistic for scapegoat effects.

Keywords: Foreign exchange microstructure, Unstable fundamentals, Scapegoat theory

JEL Classification: F31, F41, G15

Suggested Citation

Lindahl, Anna and Moore, Michael John and Rime, Dagfinn and Shehadeh, Ali, Herding the Scapegoats: Foreign Exchange Order Flow and the Time-Varying Effect of Fundamentals (March 21, 2014). Available at SSRN: https://ssrn.com/abstract=2442742 or http://dx.doi.org/10.2139/ssrn.2442742

Anna Lindahl

Stockholm School of Economics - Department of Finance ( email )

SE-113 83 Stockholm
Sweden

Michael John Moore (Contact Author)

University of Warwick - Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

Dagfinn Rime

BI Norwegian Business School ( email )

Nydalsveien 37
Oslo, 0442
Norway
+47-46410507 (Phone)

HOME PAGE: http://home.bi.no/dagfinn.rime/

Ali Shehadeh

Queen's University Belfast - Finance ( email )

United Kingdom

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