Hostname: page-component-76c49bb84f-vcmr7 Total loading time: 0 Render date: 2025-07-10T05:22:04.683Z Has data issue: false hasContentIssue false

Foreign Exchange Order Flow as a Risk Factor

Published online by Cambridge University Press:  08 July 2025

Craig Burnside*
Affiliation:
https://ror.org/00py81415 Duke University Department of Economics University of Glasgow Adam Smith Business School
Mario Cerrato
Affiliation:
University of Glasgow Adam Smith Business School mario.cerrato@glasgow.ac.uk
Zhekai Zhang
Affiliation:
Shenzhen Audencia Financial Technology Institute; Audencia Business School Nanjing Audit University zhangzhekai@szu.edu.cn
*
craig.burnside@duke.edu (corresponding author)
Rights & Permissions [Opens in a new window]

Abstract

Core share and HTML view are not available for this content. However, as you have access to this content, a full PDF is available via the ‘Save PDF’ action button.

We propose a novel pricing factor for currency returns motivated by the market microstructure literature. Our factor aggregates order flow data to provide a measure of buying and selling pressure related to conventional currency trading strategies. It successfully prices the cross-section of currency returns sorted on the basis of forward discount and momentum. The association between our factor and currency returns differs according to the customer segment of the foreign exchange market. In particular, it appears that financial customers are risk-takers in the market, while nonfinancial customers serve as liquidity providers.

Information

Type
Research Article
Creative Commons
Creative Common License - CCCreative Common License - BY
This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (http://creativecommons.org/licenses/by/4.0), which permits unrestricted re-use, distribution and reproduction, provided the original article is properly cited.
Copyright
© The Author(s), 2025. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We thank an anonymous referee, Hendrik Bessembinder (the editor), Vania Stavrakeva, and participants at the Imperial College 2019 Annual Conference in International Finance for helpful comments and suggestions.

References

Barber, B. M., and Odean, T.. “The Behavior of Individual Investors.” In Handbook of the Economics of Finance, Vol. 2B, Chap. 22, Constantinides, G. M., Harris, M., and Stulz, R. M., eds. Amsterdam, Netherlands: Elsevier (2013), 15331570.Google Scholar
Bilson, J. F. O.The “Speculative Efficiency” Hypothesis.” Journal of Business, 54 (1981), 435451.10.1086/296139CrossRefGoogle Scholar
Breedon, F.; Rime, D.; and Vitale, P.. “Carry Trades, Order Flow, and the Forward Bias Puzzle.” Journal of Money, Credit and Banking, 48 (2016), 11131134.10.1111/jmcb.12328CrossRefGoogle Scholar
Brunnermeier, M. K.; Nagel, S.; and Pedersen, L. H.. “Carry Trades and Currency Crashes.” NBER Macroeconomics Annual, 23 (2008), 313348.10.1086/593088CrossRefGoogle Scholar
Burnside, C. “A Note on Sorts and Cross-Sectional Regressions.” Working Paper, Duke University (2010).Google Scholar
Burnside, C.The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk: Comment.” American Economic Review, 101 (2011), 3456–76.10.1257/aer.101.7.3456CrossRefGoogle Scholar
Burnside, C.Carry Trades and Risk.” In Handbook of Exchange Rates, Chap. 10, James, J., Marsh, I., and Sarno, L., eds. Hoboken, NJ: Wiley (2012), 283312.10.1002/9781118445785.ch10CrossRefGoogle Scholar
Burnside, C.The Carry Trade in Industrialized and Emerging Markets.” Journal Economia Chilena, 17 (2014), 4878.Google Scholar
Burnside, C.Identification and Inference in Linear Stochastic Discount Factor Models with Excess Returns.” Journal of Financial Econometrics, 14 (2016), 295330.10.1093/jjfinec/nbv018CrossRefGoogle Scholar
Burnside, C.; Eichenbaum, M.; Kleshchelski, I.; and Rebelo, S.. “Do Peso Problems Explain the Returns to the Carry Trade?Review of Financial Studies, 24 (2011a), 853891.10.1093/rfs/hhq138CrossRefGoogle Scholar
Burnside, C.; Eichenbaum, M.; and Rebelo, S.. “Carry Trade and Momentum in Currency Markets.” Annual Review of Financial Economics, 3 (2011b), 511535.10.1146/annurev-financial-102710-144913CrossRefGoogle Scholar
Cerrato, M.; Sarantis, N.; and Saunders, A.. “An Investigation of Customer Order Flow in the Foreign Exchange Market.” Journal of Banking & Finance, 35 (2011), 18921906.10.1016/j.jbankfin.2010.12.003CrossRefGoogle Scholar
Cochrane, J. H. Asset Pricing:(Revised Edition), Princeton, NJ: Princeton University Press (2009).Google Scholar
Engel, C.The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence.” Journal of Empirical Finance, 3 (1996), 123192.10.1016/0927-5398(95)00016-XCrossRefGoogle Scholar
Evans, M. D., and Lyons, R. K.. “Order Flow and Exchange Rate Dynamics.” Journal of Political Economy, 110 (2002), 170180.10.1086/324391CrossRefGoogle Scholar
Evans, M. D., and Lyons, R. K.. “Understanding Order Flow.” International Journal of Finance and Economics, 11 (2006), 323.10.1002/ijfe.287CrossRefGoogle Scholar
Evans, M. D., and Rime, D.. “Micro Approaches to Foreign Exchange Determination.” In Handbook of Exchange Rates, Chap. 3, James, J.; Marsh, I.; and Sarno, L., eds. Hoboken, NJ: Wiley (2012).Google Scholar
Evans, M. D., and Rime, D.. “Microstructure of Foreign Exchange Markets.” Norges Bank Working Paper No. 6/2019 (2019).10.2139/ssrn.3345289CrossRefGoogle Scholar
Evans, M. D. D. Exchange-Rate Dynamics. Princeton, NJ: Princeton University Press (2011).Google Scholar
Fama, E. F.Forward and Spot Exchange Rates.” Journal of Monetary Economics, 14 (1984), 319–38.10.1016/0304-3932(84)90046-1CrossRefGoogle Scholar
Fan, Z.; Londono, J. M.; and Xiao, X.. “Equity Tail Risk and Currency Risk Premiums.” Journal of Financial Economics, 143 (2022), 484503.10.1016/j.jfineco.2021.05.020CrossRefGoogle Scholar
Galati, G.; Heath, A.; and McGuire, P.. “Evidence of Carry Trade Activity.” BIS Quarterly Review, September (2007), 27–41.Google Scholar
Hansen, L. P.Large Sample Properties of Generalized Method of Moments Estimators.” Econometrica, 50 (1982), 10291054.10.2307/1912775CrossRefGoogle Scholar
Hansen, L. P., and Hodrick, R. J.. “Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis.” Journal of Political Economy, 88 (1980), 829853.10.1086/260910CrossRefGoogle Scholar
Hansen, L. P., and Jagannathan, R.. “Assessing Specification Errors in Stochastic Discount Factor Models.” Journal of Finance, 52 (1997), 557590.10.1111/j.1540-6261.1997.tb04813.xCrossRefGoogle Scholar
Harvey, C. R., and Siddique, A.. “Conditional Skewness in Asset Pricing Tests.” Journal of Finance, 55 (2000), 12631295.10.1111/0022-1082.00247CrossRefGoogle Scholar
He, Z.; Kelly, B.; and Manela, A.. “Intemediary Asset Pricing: New Evidence from Many Asset Classes.” Journal of Financial Economics, 126 (2017), 135.10.1016/j.jfineco.2017.08.002CrossRefGoogle Scholar
He, Z., and Krishnamurthy, A.. “Intermediary Asset Pricing.” American Economic Review, 103 (2013), 732770.10.1257/aer.103.2.732CrossRefGoogle Scholar
King, M. R.; Osler, C. L.; and Rime, D.. “The Market Microstructure Approach to Foreign Exchange: Looking Back and Looking Forward.” Journal of International Money and Finance, 38 (2013), 95119.10.1016/j.jimonfin.2013.05.004CrossRefGoogle Scholar
Kleibergen, F., and Paap, R.. “Generalized Reduced Rank Tests using the Singular Value Decomposition.” Journal of Econometrics, 133 (2006), 97126.10.1016/j.jeconom.2005.02.011CrossRefGoogle Scholar
Koijen, R. S. J., and Yogo, M.. “A Demand System Approach to Asset Pricing.” Journal of Political Economy, 127 (2019), 14751515.10.1086/701683CrossRefGoogle Scholar
Lustig, H.; Roussanov, N.; and Verdelhan, A.. “Common Risk Factors in Currency Markets.” Review of Financial Studies, 24 (2011), 37313777.10.1093/rfs/hhr068CrossRefGoogle Scholar
Lustig, H., and Verdelhan, A.. “Exchange Rates in a Stochastic Discount Factor Framework.” In Handbook of Exchange Rates, James, J.; Marsh, I.; and Sarno, L., eds. Hoboken, NJ: Wiley (2012), 391420.10.1002/9781118445785.ch14CrossRefGoogle Scholar
Lyons, R. K. The Microstructure Approach to Exchange Rates, Vol. 12. Cambridge, MA: MIT Press (2001).10.7551/mitpress/4602.001.0001CrossRefGoogle Scholar
Meese, R. A., and Rogoff, K.. “Empirical Exchange Rate Models of the Seventies: Do they Fit Out of Sample?Journal of International Economics, 14 (1983), 324.10.1016/0022-1996(83)90017-XCrossRefGoogle Scholar
Menkhoff, L.; Sarno, L.; Schmeling, M.; and Schrimpf, A.. “Carry Trades and Global Foreign Exchange Volatility.” Journal of Finance, 67 (2012a), 681718.10.1111/j.1540-6261.2012.01728.xCrossRefGoogle Scholar
Menkhoff, L.; Sarno, L.; Schmeling, M.; and Schrimpf, A.. “Currency Momentum Strategies.” Journal of Financial Economics, 106 (2012b), 660684.10.1016/j.jfineco.2012.06.009CrossRefGoogle Scholar
Menkhoff, L.; Sarno, L.; Schmeling, M.; and Schrimpf, A.. “Information Flows in Foreign Exchange Markets: Dissecting Customer Currency Trades.” Journal of Finance, 71 (2016), 601634.10.1111/jofi.12378CrossRefGoogle Scholar
Osler, C. L.Market Microstructure, Foreign Exchange.” In Encyclopedia of Complexity and System Science, Myers, R. A., ed. New York, NY: Springer (2009), 54045438.10.1007/978-0-387-30440-3_321CrossRefGoogle Scholar
Ranaldo, A., and Somogyi, F.. “Asymmetric Information Risk in FX Markets.” Journal of Financial Economics, 140 (2021), 391411.10.1016/j.jfineco.2020.12.007CrossRefGoogle Scholar
Sarno, L., and Taylor, M. P.. “The Microstructure of the Foreign-Exchange Market: A Selective Survery of the Literature.” Princeton Studies in International Economics No. 89. Princeton, NJ: Princeton University (2001).Google Scholar
Villanueva, O. M.Forecasting Currency Excess Returns: Can the Forward Bias Be Exploited?Journal of Financial and Quantitative Analysis, 42 (2007), 963990.10.1017/S002210900000346XCrossRefGoogle Scholar
Zhang, S.Dissecting Currency Momentum.” Journal of Financial Economics, 144 (2022), 154173.10.1016/j.jfineco.2021.05.035CrossRefGoogle Scholar
Supplementary material: File

Burnside et al. supplementary material

Burnside et al. supplementary material
Download Burnside et al. supplementary material(File)
File 134.5 KB