Expectation Errors in the Foreign Exchange Market

Abstract

This paper argues that order flow can explain exchange rate forecasting errors.  A unified theoretical model is developed showing that forecasting errors can be explained by both informational rigidities and portfolio shifts.  This is applied to Brazilian data using a unique data set of daily consensus exchange rate forecasts managed by the Banco Central do Brasil along with order flow derived from the FX futures market.  The results strongly support the theory.