Equity order flow and exchange rate dynamics

This paper contributes to the literature on international portfolio choice in several ways. First, I generalize the model of Dunne et al. (2010) and derive order flow as the result of correlated belief changes by heterogeneous investors. This strategy delivers testable implications for the daily dynamics of stock flows, equity returns, and exchange rate changes. Second, I empirically confirm these conditions using fifteen years of high-frequency data for US stocks and daily data for twenty US bilateral exchange rates. Third, the model relies on differences in the volatility of country-specific shocks to account for the empirical results. It can explain why the ‘portfolio rebalancing motive’ is not important for commodity countries, as well as the asymmetric structure of currency and stock returns.

► I model stock order flow with correlated belief changes by heterogeneous investors.
► Robust empirical results confirm the model dynamics for currencies and stocks.
► This joint dynamics is driven by the relative volatility of country-specific shocks.
► For most countries, results are consistent with the portfolio rebalancing channel.
► Commodity countries are different due to the high volatility of their terms-of-trade.