ABSTRACT
A recent strand of research in exchange rate economics investigates the microstructure of foreign exchange (FX) markets and the impact of trading activity on exchange-rate dynamics. The principal result of this new strand is that order flow is an important determinant of exchange-rate dynamics in the short-term and possibly even in the medium-term.1 Theoretical underpinnings of this empirical result link the explanatory power of order flow to two different channels of transmission, due respectively to portfolio-balance and information effects. With respect to the former channel, it has simply been suggested that trade innovations perturb the inventories of FX investors which need to be compensated with a shift in expected returns.
