AbstractsBusiness Management & Administration

Exchange rates have proven to be one of the most evasive variables of macroeconomics. Not only are they notoriously difficult to forecast, they appear surprisingly unrelated to fundamentals even at longer horizons. Despite many proposed models and theories for their behaviour, they remained largely unexplained until the turn of the millennium. The last decade has seen a surge of literature on trade flows in the \protect\ac{FX}-market, dubbed order flow, used to explain the exchange rate movement. This thesis outlines a set of stylized facts of the empirical literature so far. It suggests, discusses and proposes ways of testing three explanations for why order flows have explanatory power for exchange rates. The explanations are not mutually exclusive. The explanations were, therefore, hierarchically tested on each channel of price impact, starting with the most conservative. The first explanation attaches the least economic significance to order flow, and assigns the price impact to search frictions in the market resulting in liquidity disruptions. This would cause order flow to have potentially significant price impact, but only over short time intervals, as searching takes place over a limited period. I therefore propose to test this implication by testing for persistent price impact from order flow. A second explanation is that order flow has price impact because it is a signal on market risk premiums. This risk premium umbrella contains both the view that order flows move price as a result of shifts in demand, i.e.\ due to portfolio shifts, and the view that it is due to a more general risk aggregation. This explanation implies that order flow can have permanent price impact, but the information that order flow carries should be about risk premiums and therefore unrelated to macro fundamentals. If all price relevant information contained in order flow is about risk premiums, then order flow should be orthogonal to macro. Explanatory power for the residuals from a standard macro exchange-rate model was therefore tested to reveal potential orthogonality assigning the price-relevant information in order flow contains to risk premiums. The final explanation for the price impact of order flow is that it contains some deep information about the economy. If this is an important channel through which order flows affect the exchange rate, then order flows ought to display some covariance with the macro fundamentals they carry information about. Although this is not a decisive test, it might give some indication of whether this is an important channel. The proposed test for informational content on macro fundamentals is in essence a test of the contrary. If some of the observed price impact of order flow cannot be subscribed to any of the other proposed explanations, then this channel has to play a role in the determination of exchange rates. The results revealed that order flow from the Norwegian FX-market has a significant positive and persistent price impact, similar to reports from other FX-markets. The…