Market Microstructure Approach to the Exchange Rate Determination Puzzle
The IUP Journal of Monetary Economics, Vol. VII, Nos. 3 & 4, pp. 101-115, August & November 2009
Posted: 26 Aug 2009
Date Written: August 25, 2009
Market microstructure approach claims that the imbalances between ‘buyer-initiated and seller-initiated trades’ in foreign exchange markets are indicative of the transmission link between exchange rates and fundamental determinants of exchange rates. In the context of the exchange rate determination puzzle, this paper uses Autoregressive Distributed Lag (ARDL) model to discuss the market microstructure approach from the standpoint of hybrid models that integrate order flow, fundamentals and non-fundamental variables to establish the determinants of the rand-dollar exchange rate. Among the non-fundamentals considered are the Economist’s commodity price index, and a proxy for country risk - the differential between the Global Emerging Market Bond Index and the South African long-term bond. The results, based on the Schwarz Bayesian Criterion, used for choosing a model’s lag length, show that there is a long-run relationship between the rand-dollar real exchange rate, non-fundamentals, fundamentals and the proxy for order flow, which is the dollar-denominated daily net turnover in the South African markets.
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