Foreign Exchange Market Microstructure - Georgetown University

Foreign Exchange Market Microstructure Martin D. D. Evans 1 Georgetown University and NBER Abstract This paper provides an overview of the recent literature on Foreign Exchange Market Microstructure. Its aim is not to survey the literature, but rather to provide an introductory tour to the main theoretical ideas and empirical results. The central theoretical idea is that trading is an integral part of the process through which information relevant to the pricing of foreign currency becomes embedded in spot rates. Micro-based models study this information aggregation process and produce a rich set of empirical predictions that find strong support in the data. In particular, micro-based models can account for a large proportion of the daily variation in spot rates. They

also supply a rationale for the apparent disconnect between spot rates and fundamentals. In terms of forecasting, micro-based models provide out-of- sample forecasting power for spot rates that is an order of magnitude above that usually found in exchange-rate models. Keywords: Exchange Rates, Microstructure, Information Aggregation, FX Trading. JEL No. F3, F4, G1 1 Department of Economics, Georgetown University, Washington DC 20057, Tel: (202) 687-1570, Email: evansm1@georgetown.edu. This paper was prepared for the New Palgrave Dictionary of Economics. I thank Richard Lyons for valuable discussions and gratefully acknowledge the financial support of the National Science Foundation. 1 Introduction Models of foreign exchange (FX) market microstructure examine the determination and behavior of spot exchange rates in an environment that replicates the key features of trading in the FX market. Traditional macro exchange rate models play little attention to how trading in the FX market actually takes place. The implicit assumption is that the details of trading (i.e., who quotes currency prices and how trade takes place) are unimportant for the behavior of exchange rates over months, quarters or longer. Micro-based models, by contrast, examine how information relevant to the pricing of foreign currency becomes reflected in the spot exchange rate via the trading process. According to this view, trading is not an ancillary market activity that can be ignored when considering exchange rate behavior. Rather, trading is an integral part of the process through which spot rates are determined and evolve. Recent micro-based FX models also differ from other areas of microstructure research in their focus on the links between trading, asset price dynamics, and the macroeconomy. Recent research on exchange rates stresses the role of heterogeneity (e.g., Bacchetta and van Wincoop 2003, and Hau and Rey 2002). Micro-based exchange- rate models start from the premise that much of the information about the current and future state of the economy is dispersed across agents (i.e., individuals, firms, and financial institutions). Agents use this information in making their every-day decisions, including decisions to trade in the FX market at the prices quoted by dealers. Dealers quote prices (e.g. dollars per unit of foreign currency) at which they stand ready to buy or sell foreign currency; they will purchase foreign currency at their bid quote, and sell foreign currency at their ask quote. Agents that choose to trade with an individual dealer are termed the dealer’s customers. The difference between the value of...

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