Understanding order flow
This paper develops a model for understanding end-User order flow in the FX market. The model addresses several puzzling findings. First, the estimated price-impact of flow from different end-user segments is, dollar-for-dollar, quite different. Second, order flow from segments traditionally thought to be liquidity-motivated actually has power to forecast exchange rates. Third, about one-third of order flow's power to forecast exchange rates 1 month ahead comes from flow's ability to forecast future flow, whereas the remaining two-thirds applies to price components unrelated to Future flow. We show that all of these features arise naturally from end-User heterogeneity, in a setting where order flow provides timely information to market-makers about the state of the macro-economy. Copyright (c) 2006 John Wiley & Sons, Ltd.