DP4530 | A Guided Tour of the Market Microstructure Approach to Exchange Rate Determination

Author(s)

Publication Date

23/08/2004

JEL Code(s)

Keyword(s)

Programme Area(s)

Abstract

We propose a critical review of recent developments in exchange rate economics. This new strand of research is motivated by some very stark empirical evidence, relating exchange rate returns to order flow. Plenty of empirical evidence shows that order flow, i.e. the imbalance in the sequence of purchases and sales of foreign currencies in the markets for foreign exchange, is an extremely powerful determinant of short-run exchange rate movements. With a simplified analytical framework we see how, according to the rational expectation paradigm of asset pricing, such a relation reflects liquidity and information effects of portfolios shifts.