An empirical study of portfolio-balance and information effects of order flow on exchange rates

We propose a simple structural model of exchange rate determination which is inspired by the analytical framework recently forward by Bacchetta and van Wincoop (2006) and allows us to disentangle the portfolio-balance and information effects of order flow on exchange rates. We estimate this model employing an innovative transaction data-set that covers all indirect foreign exchange transactions completed in the USD/EUR market via EBS and Reuters between August 2000 and January 2001. Our results indicate that the strong contemporaneous correlation between order flow and exchange rates is largely due to portfolio-balance effects. This result also appears to carry through the four FX intervention events that appear in our sample.