Associate Professor and Program Director, Brandeis University
Graduate Student, Brandeis University
This chapter focuses on the microstructure of the foreign exchange market, the largest financial market in the world. Average daily foreign exchange trading exceeds $4 trillion, according to the Bank for International Settlements (2010), a figure that is roughly 20 times daily U.S. equity trading volume (CNN 2012). Nonetheless, the foreign exchange market has been less intensively studied than other markets, possibly because currencies emerged only in the past two decades as a major focus of speculative activity.
The disappointing empirical performance of exchange rate models developed in the 1970s sparked academic interest in the foreign exchange market. When the Bretton Woods system of fixed exchange rates collapsed in 1973, rates began to float worldwide for the first time in history. Because little evidence was available on floating rates, economic modelers first adopted untested assumptions. Many of those, including continuous purchasing power parity (PPP) and uncovered interest parity (UIP), were quickly falsified by the emerging evidence (Engel 1996; Rogoff 1996). Indeed, these inductively derived models proved worse at forecasting exchange rates than the simple random walk hypothesis (Meese and Rogoff 1983). A more deductive, first-the-facts approach seemed worth a try, so economists began ...