Asymmetric Price Impacts of Order Flow on Exchange Rate Dynamics∗

Abstract

We generalize the portfolio shifts model of exchange rate determination advanced by Evans and Lyons (2002a; b). Our model allows for asymmetric price impacts of order flow, and for persistent mispricing. Using the Reuters D2000-1 dataset, we find strong evidence of an asymmetric cointegrating relationship between the exchange rate and order flow. Specifically, the price impact of dollar-selling pressure is overwhelmingly stronger than that of dollar-buying pressure, i.e. traders respond asymmetrically to selling and buying pressures of the dollar. Our results also reveal the complex price discovery process, and different feedback trading strategies in foreign exchange markets