The Microstructure of Foreign Exchange Dynamics

Abstract

This paper studies the high frequency behavior of the interbank foreign exchange market with a newly created data set that provides the most comprehensive picture of activity across the market in existence. My analysis indicates that trade activity within the interbank market is distinct from the posting of indicative quotes. Trading and quote-making decisions are linked, but the links are complicated and poorly understood. I also document the existence of a strong relationship between exchange rate movements and a measure of excess Dollar demand. A trading model is analyzed to show how the structure of the market could give rise to such a microstructure effect. Empirically, this effect appears important in the determination of exchange rates at high frequencies and over longer time spans relevant in international macroeconomics.

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