Microstructure and Adjustment Process in Foreign Exchange Markets: Short-term Dynamics

Abstract

This paper models forex market as an automatic feedback control system that maintains Uncovered Interest Rate Parity (UIRP) as the no-arbitrage equilibrium condition. The process of adjustment in the face of exogenously introduced interest rate news is specified by simple intuitive dynamics of demand and price formation. The model illustrates that the microstructure of price and demand formation itself contributes significantly to short-term return volatility. The market is necessarily inefficient in the short-term owing to finite settling time arising out of the adjustment process specified by the microstructure, but efficient in the long run in the absence of any information bias on the part of participants. Furthermore, when the time interval between successive interest rate news arrivals is smaller than the market's settling time or when there is information bias, volatility and mis-pricing persist in the long run. Microstructure and information bias jointly explain the persistent time varying deviations from UIRP and profitability of technical analysis over the short-run reported in literature. Measures for volatility and efficiency are proposed and the effects of market parameters and transaction tax on these measures are analyzed.