Microstructure Theory and the Foreign Exchange Market

Abstract

GROWING BODY OF theoretical literature, known as the study of securities market microstructure, deals with the behavior of participants in securities markets and with the effects of information and institutional rules on the economic performance of those markets. These institutional factors may arise from technology, tradition or regulation. Microstructure and its impact are important, because of the vast amounts of wealth which pass through securities marketsincluding the foreign exchange marketevery day.Microstructure is of interest to students of the foreign exchange market: microstructural analyses of other markets have yielded insight into traders' behavior and the effect of various institutional arrangements. Conversely, the foreign exchange market is also of special interest to students of microstructure, because it combines two very different arrangements for matching buyers and sellers -bank dealers trade with one another both directly and through foreign exchange brokers.1Standard models of exchange-rate determination concentrate on relatively long-run aspects, such as purchasing power parity. While microstructure theory cannot address these issues directly, it can illuminate a more narrowly focused array of institutional concerns, such as price information, the matching of buyers and sellers, and optimal dealer pricing policies. Despite the substantial literature on microstructure, little attention has been paid to the particular microstructure of the foreign exchange market.2 'Similar arrangements exist for other securities-for example, the federal funds market and the secondary market for Treasury securities-but these too have been relatively neglected in the literature. 2 The shaded insert on the opposite page provides a context in which the microstructural approach can be compared with more traditional approaches to market efficiency. Following some early articles by Demsetz (1968), Tinic (1972 and Tinic and West (1972), Garman (1976) performed the crucial task of defining market microstructure as an independent area of the literature, thus focusing the debate. Since then, market microstructure has burgeoned, led by

Market structure and inefficiency in the foreign exchange market

“…Bossaerts and Hillion (1991) provide a valuable application of theoretical microstructural analysis to the foreign exchange market. Flood (1991) offers an overview of microstructural theories in the context of the foreign exchange market.…”

Research Progress of Algorithmic Trading at Home and Abroad

“…Therefore, the investors can quickly trade any order size. In fact, the liquidity cost of the orders is very large in the short term liquidity shortage [8][9][10] . Therefore, the research and control of transaction costs is very important.…”

Predicting Exchange Rates via a Futures Market

“…It is obvious that traders' behavior determines prices (Flood 1991). However, market participants appear to be using different models when predicting future rates.…”