Foreign exchange market microstructure

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-ofsample forecasting power for spot rates that is an order of magnitude above that usually found in exchange-rate models.

Periodic Sequences of Arbitrage: A Tale of Four Currencies

“…This means that market information is fragmented, FX dealers having private information about the transactions forthcoming at their own quoted bid and offer prices, and having access to the public information regarding the order flows accumulated by the FX brokers. For analysis, discussion and evidence regarding how order flows impact on intra‐day exchange rates see Evans and Lyons (2002), Sarno and Taylor (2001) and Evans and Lyons (2008).…”