Inside the Black Box: Why are Order Flows Models of Exchange Rate more competitive than Traditional Models of Exchange Rate?

This article looks inside the black box of order flows to understand why order flows models of exchange rate are more competitive than traditional models of exchange rate. We set a theoretical model that relies on a behavioural exchange rate model and a microstructure model. The model puts forward three results. First, simulations replicate stylised facts observed in the foreign exchange market. Secondly, the model shows that the foreign exchange market is intrinsically inefficient. Incoming information is distorted by behavioural noise and microstructure noise. Thirdly, order flows models of exchange rate provide an answer to the exchange rate disconnection puzzle. Indeed, order flows contain processed information i.e. a time varying weight of fundamental information, behavioural information and microstructure information while traditional models only consider raw information i.e. fundamental information.