The foreign exchange market turns out to be the largest financial market in the world. Conventional macroeconomic theories do not account for why people trade in foreign exchange, and they do not explain the short-run determinants of the exchange rate. In the absence of a detailed model of the determinants of short-term fluctuations, it is important to understand the microstructure of currency markets. This chapter explores the role of the microstructure of currency markets in explaining exchange rate behavior.
In this section, we examine the microstructure of currency markets.
This includes the structure of the markets and the behavior of the participants. It also focuses on the processes of price formation and price discovery. The microstructure of currency markets can be characterized by several factors, including transaction costs, timing costs, counterparty asset tracking, and liquidity.
Some of the most important factors for understanding the microstructure of currency markets are discussed below.
One of the microstructure factors focuses on how prices are determined. Some markets use an auction process, while others post prices that buyers can decide to purchase. These factors affect the pricing processes. Other microstructure factors focus on the quality of information that is available to the market. In particular, this factor reflects the price of a currency pair. The market’s breadth and spread are important components of this aspect. Other factors that influence the price are trading volumes, counterparty asset tracking, and information disclosure.
Microstructure and the Foreign Exchange Market
The study of foreign exchange market microstructure is critical for understanding why investors choose to trade this instrument, as it is the world’s largest financial market. Analyzing the microstructure of the foreign exchange markets, focusing on institutional aspects and the actual behavior of participants includes the size and volatility of the bid-ask spread, price formation, trading volumes, and counterparty asset tracking. Nevertheless, the theories presented in microstructure studies are relevant to the understanding of why exchange rates fluctuate. Moreover, the research on currency markets is gaining momentum as more people become interested in the global economy. The growing popularity of the currency market and increased risk-taking have prompted more research on the subject. It also addresses the importance of order flow in the foreign exchange market, as well as the heterogeneity of agents’ expectations.