Exchange Rate Economics: Theories and Evidence

Market microstructure approach 345
for the Japanese yen. However,although there are differences in forecasting
performance MacDonald and Marsh demonstrate that very few forecasters outperform
a random walk at short horizons,although a substantial number do over
longer horizons.
14.2 Institutional description of the market and
market classification 2
In this section we consider some of the institutional aspects of the foreign exchange
market,which have a direct bearing on the market microstructure literature. As we
have seen,the institutional structure of a market is crucial for proponents of the
market microstructural view,since institutional differences can affect the efficiency
of pricing and allocation.
As we saw in Chapter 1,the foreign exchange market differs from some other
financial markets in having a role for three types of trade: interbank trade,which
accounts for the majority of foreign exchange trade; trade conducted through
brokers,which represents the second largest proportion of trade; trade undertaken
by private customers (e.g. corporate trade),which represents the smallest amount
of trade in the foreign exchange market. The latter group have to make their
transactions through banks,since their credit-worthiness cannot be detected by
brokers.
Cheung and Chinn (1999) use data from a survey of US-based foreign exchange
traders to gain further insight into the operation of the foreign exchange market.
In particular,their survey ‘attempts to ascertain directly how market participants
behave,document their experiences,and solicit their views on the workings of the
foreign exchange market’. The survey was conducted between October 1996 and
November 1997 and out of a total of 1796 market participants mailed,142 completed
questionnaires were returned to the authors. Some interesting results stem
from this survey. First,their survey reveals that in 1992 transactions were apportioned
equally between interbank and traditional broker trades but by 1996–7
interbank transactions had fallen to about one-third of the total and traditional
brokers lost considerable ground to electronic brokers,such that the latter represented
46% of total trade and the former only 17%. Cheung and Chinn also
show that traders have a range of what they regard as conventional spreads –
five basis points for the Swiss franc and UK pound against the US dollar and
three basis points for the German mark and Japanese yen against the US dollar.
In practice Cheung and Chinn find that only a small proportion of bid–ask spreads
deviate from the convention (we return later to this point). 3
As Lyons (2001) notes,the foreign exchange market is distinct from other asset
markets in a number of ways. For example,in the foreign exchange market there
is no physical location where dealers meet with customers. Furthermore,the transparency
of trade is quite different to other asset markets such as equity or bond
markets. In these national markets,trades usually have to be disclosed by law within
minutes of trade taking place,whereas in the foreign exchange market there is no
requirement for such disclosure. If order flow is not generally observed then this