A comparative study of exchange rates and order flow based on wavelet transform coherence and cross wavelet transform

Abstract Understanding the relationship and behavior of microstructures and exchange rates is an essential discussion for global foreign exchange investors. There are numerous research works regarding the linkage between order flow and exchange rates, yet the exact relationship between the order flow and the market price that indicates whether participants have an impact on the market trend remains undefined. This paper investigates the empirical association and behavior of order flow and the exchange rate movements within the time-frequency space, on three popular currency pairs, using the cross wavelet transform and wavelet transform coherency. The results indicate that order flow has a strong negative correlation and is the leader variable of the exchange rate. A predictor using order flow as an input variable was implemented to forecast the exchange rate direction using the sample data and out-of-sample data. This methodology, which performs with high accuracy and very low drawdown, could be a suitable tool for portfolio managers and forex participants during their trading activities.