DP4806 Macroeconomic Order Flows: Explaining Equity and Exchange Rate Returns

Author(s): Peter Dunne , Harald Hau , Michael Moore

Publication Date: December 2004

Keyword(s): international macroeconomics , equities , exchange rates , microstructure

JEL(s): F30 , F31 , G10 , G15

Programme Areas: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP4806.asp

Macroeconomic models of equity returns perform poorly. The proportion of daily index returns that these models explain is essentially zero. Instead of relying on macroeconomic determinants, our model includes a concept from microstructure order flow. Order flow is the proximate determinant of price in all microstructure models. We explain aggregate equity returns as well as exchange rates in a model with heterogenous beliefs. Belief changes are shown to be observable through order flow. To test the model we construct daily aggregate order flow data from all equity trades in the U.S. and France from 1999 to 2003. Almost 60% of the daily returns in the S&P100 index are explained jointly by exchange rate returns and macroeconomic order flows.