Foreign Exchange Order Flow as a Risk Factor

This paper proposes a set of novel pricing factors for currency returns that are motivated by microstructure models. In so doing, we bring two strands of the exchange rate literature, namely market-microstructure and risk-based models, closer together. Our novel factors use order flow data to provide direct measures of buying and selling pressure related to carry trading and momentum strategies. We find that they appear to be good proxies for currency crash risk. Additionally, we show that the association between our order-flow factors 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 non-financial customers serve as liquidity providers.