Handbook of Exchange Rates

3.3 Currency Trading Models and their Implications

One goal of micro-based research is to build exchange-rate models from microeconomic foundations that reasonably represent the key features of the FX market. In particular, the aim is to incorporate the institutional implications of how information is transmitted from one agent to another as trading takes place and to study how this information flow is ultimately reflected in the spot exchange rate.

No model can incorporate all the institutional features of trading in the FX market—it is far too complex. Instead, micro-based models focus on a small number of features that are viewed as essential for understanding the main economic mechanisms at work. The structure of the FX market is discussed in more detail in the chapter by King et al. We summarize the key features below.

FX dealers working in banks are the key intermediaries in the FX market. The FX market is a two-tier market in the sense that the end-users of currency trade with dealers in the retail market, and dealers trade with other dealers in the interbank market. Neither the interbank nor the retail market has a physical location. Trades are made by phone or electronically between participants located all around the world, and trading can take place continuously 24 hours a day. However, a majority of the trading in the interbank market involve banks in a few financial centers (Tokyo, Singapore, Frankfurt, New York, and particularly London), and activity is heavily concentrated ...