ABSTRACT
Up to this point the focus has been on the macroeconomics of exchange rate behaviour and we have argued, either directly or indirectly, that this focus is a valuable one. However, there are still important issues to address with respect to understanding the daily volume of foreign exchange traded globally and how the price of foreign exchange is actually set in the foreign exchange market. For example, we noted in Chapter 1 that on a day-to-day basis the current BIS estimate of the volume of gross trading in foreign exchange markets on a global basis is approximately $1.2 trillion, 1 86% of which occurs between market makers alone. Since the total annual world trade flow is around $4 trillion it is clearly difficult to explain the massive foreign exchange trade in terms of standard macroeconomic fundamentals and therefore a number of researchers (see, for example, Frankel and Rose 1995a; Flood and Rose 1999; Lyons 2001) have proposed using a microeconomic-based modelling approach, namely, a market microstructure approach. This micro-based approach focuses on an array of institutional aspects of the foreign exchange market, such as price formation, the matching of buyers and sellers (i.e. market makers and brokers) and optimal dealer pricing policies.
