Ebook Macroeconomic Order Flows: Explaining Equity and Exchange Rate Returns
The aggregate stock market index and the exchange rate are known to have a very low correlation with any other measurable macroeconomic variable (Frankel and Rose (1995), Rogoff (2001)). This motivates us to examine a new financial market variable called order flow in its relationship to stock and exchange rate returns. Order flow is the net of buy minus sell initiated orders. In the forex market, daily exchange rate returns and daily forex order flow show a remarkably high correlation (Evans and Lyons (2002a, 2002b, 2002c)) and even permanent changes in the exchange rate appear to be explained by order flow. Unfortunately, most of the microstructure literature features order flow as an exogenous variable. Its very origin remains unexplained and open to different interpretations.
This paper advances the existing literature in two directions. First, we add micro foundations to the existing literature on order flow. We link the order flow concept to heterogenous belief changes of investors and therefore allow for a coherent interpretation. It is argued that the portfolio reallocations resulting from belief changes are predominantly pursued through trade initiation. Recent evidence from the microstructure literature (Hollifield et al. (2004)) confirms that the likelihood of trade initiation increases with the magnitude of the deviation between agents’ valuations and the current mid price of a stock. Since order flow represents a summary statistic on the direction of trade initiation, it directly identifies aggregate belief changes. Second, we propose a two country model in which two equity markets and the exchange rate market can be analyzed jointly. The multi market setting imposes testable restrictions on international market interdependence.
On the empirical side, we show that an extraordinarily high percentage of the daily aggregate equity return variation can be explained jointly by the exchange rate and marcoeconomic order flows. For the S&P100 we are able to explain around 60 percent of the daily return variation and for the CAC40 approximately 40 percent. In accordance with theory, the return dynamics in both equity markets does not only depend on the own market order flow, but also significantly on the order flow in the overseas market. This market interdependence appears to be well explained by heterogenous belief shifts across different investor types. We also show that time varying risk primia defined as the deviations from uncovered equity parity can be well explained by our model. This contrasts with the shortcomings of existing models to account for deviations from uncovered interest parity. Uncovered equity parity (Hau and Rey (2003)) is the analogue to uncovered interest parity in our model.
Heterogenous beliefs and their change is the focus of our inquiry. Survey data suggests that international differences in equity return beliefs are in fact important. Shiller et al. (1996) document large aggregate differences of opinion on the price expectations of the Nikkei and S&P100 index across Japanese and American fund managers. Hau and Rey (2005) group international fund managers by their location and document large common components with respect to international fund allocations. Such international equity reallocations in turn trigger order flow in the FX market. Belief changes about equity returns therefore also influence the exchange rate return.
Our paper also relates to a recent literature which focuses on the role of order flow in the U.S. equity market. Hasbrouck and Seppi (2001) show that commonality in the order flows of individual stocks explains roughly two-thirds of the commonality in returns. But this paper restricts itself to high frequency intervals. Chordia and Subrahmanyam (2004) study the relationship between order flow and daily returns of individual stocks. Pastor and Stambaugh (2003) find that market wide liquidity is a state variable important for asset pricing at the daily frequency. Chordia, Roll and Subrahmanyam (2002) document for the period 1988 to 1998 that aggregate order flow in the NYSE is correlated with contemporaneous daily S&P500 returns. But their regressions are not based on any structural model and show much lower explanitary power. To the best of our knowledge, no paper has tried to formally model aggregate equity returns in terms of aggregate equity order flow or related cross country differences in equity order flows to exchange rate movements.
The following section presents the model. Section 3 summarizes and explains the resulting equilibrium relationships. The data is explained in Section 4. Section 5.1 discusses the estimation results for aggregate equity returns and Section 5.2 contain our model estimation for the time varying deviations from uncovered equity parity. Section 6 concludes.
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