ORDER FLOW AND EXCHANGE RATE DYNAMICS: AN APPLICATION TO EMERGING MARKETS

The paper examines short-run exchange rate dynamics in an emerging market based on the recent microstructure framework of foreign exchange markets where the main explanatory variable is the order flow of end-user customers. The study makes two main contributions to the literature: it modifies the basic microstructural FX model to take account of key features of the majority of emerging markets, namely the existence of a black market for FX and the presence of market inefficiencies; and it uses a unique database covering almost the complete Ghanaian market, and for a long time span compared with previous studies. We find that the unexpected component of order flow has a positive and long-lived effect on the official exchange rate in both stable and crisis periods, consistent with the basic microstructural approach. The price impact of unexpected order flow is related to the level of liquidity in the market. Expected order flow also impacts the exchange rate, suggesting inefficiencies in the market. Copyright (c) 2011 John Wiley & Sons, Ltd.