Market Microstructure Approach - Research Paper Example

Running head: MICROSTRUCTURE APPROACH TO EXCHANGE RATE IS RADICAL DEPATURE FROM INTERNATIONAL MICROECONOMIC MODELS Market Microstructure ApproachUniversity Name Market Microstructure Approach Market microstructure approach is taken as the study of the entire process and outcomes of assets exchange in consideration of the laid down trading rules. It is indeed a drastic move from the traditional exchange rate determination models, which only indicate the long run trends of exchange rate movements thus failing to explain the movements in the short run. This theory attempts to study behaviour of vendors in the global financial market. According to Obstfeld, M. and Kenneth, R.(1996) all the models of the exchange rate, i.e. the monetary model, asset market approach , orgarch model assumes that the current exchange rate is determined by certain important economic factors, these factors are; Economic growth Interest rates Money supplies Inflation rates and Output levels The above factors will therefore be important in answering the discussing whether the market microstructure to exchange rate has been a radical departure from the 1960's, 1970's and 1980's international macroeconomic models. This will involve assessing ach factor against a certain model thus noting the development undergone. For example, the economic growth under the monetary model of the 1960's was slow compared to the economic growth in the recent market microstructure approach. Combining these factors with the market exchange rate expectations will give us the current change value. According to the monetary model argues that relative price levels of any given two countries will provide the determinant to exchange rate. ( Obstfeld, M. and Kenneth, R, 1996) The real output level in a given country will also be a very important factor in assessing the models development; this is because it directly affects the price levels of certain goods and services. For instance, a rise in the United States output level with the other factors remaining constant will lead to a fall in the average prices in the US this will in return lead to the dollar appreciation. Past and future fundamental economic factors will matter a lot since the plays an important role of determining the future market expectations rate. Some of the traditional model of exchange rate includes asset market approach, mundell Fleming model orgarch model among others. They all had a shortcoming of failing to explain exchange rate movement's ion the long run. Mundell Fleming Model This theory was developed by Marcus Fleming and Robert Mundell in the 1960's. It was an extension of the LM model describing a small open economy. It gives the relationship between the nominal exchange rate and output of an economy in the short run. The model assures that under fixed rate regime an increase in government expenditure will shift the cure to the right. (Hamilton, 1994) This shift will increase the interest rate with the resultant effect being an appreciation of the exchange rate. In the fixed system framework the exchange will be controlled by the local momentary authority. The momentary authority stabilizes the exchange rate by using local currencies to purchase foreign currencies. This will in turn shift the LM curve in line with the direction of the IS shift, a thing that helps in lowering the exchange rate by increasing the supply of local currency in the market. However, a decrease in the government expenditure will shift the IS curve to the right. The shift will lead to a decline in the level of interest rate resulting to a depreciation of the exchange rate. (Hamilton, 1994) The central bank or relevant monetary authority will vary the money supply so as to realize a constant exchange rate level. Local authority adds its foreign reserves through increased purchase of foreign currencies using the local currency. this will lead to exchange rate appreciation.Incase it wants to depreciate the exchange rate the authority will use the foreign reserves to purchase its own currency to stabilize the situation A permanent increase in the level of exchange rate will cause revaluation interpreting to decrease in the overall money supply. On the other hand a permanent increase the money supply causing devaluation to occur. A change in the global interest rate causes capital flows to the domestic rate, which the authority will need to offset so as to maintain a fixed rate of exchange. The central bank should equalize real global interest rate with the real domestic rate of interest to avoid the scenario of net capital flow will emerge a thing that would lead to home currency depreciation. This outflow can be offset through sale of the foreign currency. A decline in the level of money supply will shift the LM curve backwards until a point where the global interest rate equalizes the domestic interest rate. (Hamilton, 1994) If a decline of the global interest rate below the domestic rate will lead to appreciation of the home currency due to the money inflows. To offset this the central bank increases money supply thought he sale of domestic currency and purchase of the foreign currency. This leads to an upward shift of the LM curve making domestic interest rate to be the global interest rate. Under flexible exchange rate regime an increase of money supply result into a lower local interest rate compared to the global interest rate. It shift the LM curve to the right resulting to an exchange rate depreciation will lead to increase exports which shifts the IS curve rightwards to a point where global interest rate equates the local interest rate. A decrease in money supply will lead to a lower global interest rate thus increasing imports and reducing exports. Increasing governmental expenditure will lead to a higher local interest rate as compared to the global rate. This will in turn shift the IS curve to the right. The capital inflow caused will strengthen local currency a thing that makes foreign goods cheaper compared to the local goods. The resultant effects being increased imports and reduced exports. (Hamilton, 1994) Asset Market Approach Similar to equity prices exchange rates are established within the assets market. The model market makes equilibrium assumptions based on, 1. Internationally traded assets. 2. The risk properties of the internationally trade assets 3. Assumption on risks of internationally investors attitudes 4. The behaviour of labour and goods market Asset market models occur in two broad categories i.e. Monetary models Portfolio balance models Monetary Models The model makes an assumption that the international investors are risk neutral meaning:- The investors take foreign and domestic bonds as perfect substitute in contrast with balance model portfolio. This means that the assets will have to pay the same expected return. (Hendry, 1999) The model realizes the impact of the exchange rate movements that are expected to the assets, which are classified in various national currencies. The model expects the differential returns to be zero since the model assumes that the domestic and foreign interest bearing assets are perfect substitutes. Return expectation in domestic currency Domestic asset foreign asset expected Differential Expected Return r r*x r-- (r*) + x NB x = expected depreciation rate in domestic currency Returns expectations in foreign currency Domestic asset foreign asset expected difference Expected Return Rx r* rx2 r* (R(r*) + x (Hendry, 1999) Simple Monetary Model According to Cheremza, W. and Derek, F.( 1997) this model makes the following assumptions People from different countries consider money as their only financial asset There are no any capital account transactions since money is not traded internationally Prices are flexible with exogenous output level Domestic prices foreign prices and exchange rates are related through the purity power principle The model suggests that an increase in the money supply will result to domestic currency depreciation of the proportional rate increment. An increase in exogenous output will cause the domestic currency to appreciate while a decline in exogenous output will result to depreciation of the domestic currency. Increase in prices will lead to domestic currency appreciation while its decrease will lead to domestic currency depreciation. (Cheremza, W. and Derek, F, 1997) Market Microstructure Market microstructure can be defined as the as that area of finance which studies the process by which investors' underlying demands are eventually translated into prices and volumes. (Hamilton, 1994) Market microstructure focuses on the markets ability in determining the prices of assets that are traded in the market a measure hat will be used in evaluating the success of any given financial market. Factors such as the interest rates, financial policy, inflation, regulatory environment and the micro factors of the market will be used determining the liquidity in the market. The past three decades have realized a remarkable growth in the financial markets as a result of radical regulatory, structural and technological changes. This has led to the market microstructure becoming an interesting field in the area of finance for market regulators, policy makers, stock exchange and academicians. (Hamilton, 1994) market microstructure touches on the price formation and price discovery a factor focusing on asset prices determination, transaction cost and timing cost which plus the impact of the transaction cost on the returns on investments, information and disclosure focusing on information about the market and it's participants behaviour and lastly, the market structure and design which focuses on the relationship between trading rules and price determination. Market structure and design will have a major impact on, liquidity, trading costs and price discovery .it refers to trading rule attributes which include, transparency, protocols, off-market trading, dealer presence, continuity degree, information distribution, continuity degree and order types. (Hamilton, 1994) About transaction cost the current online trading has played a major role thus reducing drastically the overall transaction cost. The is a major development o this model as compared to the traditional models thus allowing easy accessibility to information in different markets.. Online trading has also trimmed down the information advantage initially enjoyed by few market participants a thing that has led to profit margins reduction. They have been reacting to information swiftly because they are well informed on matter concerning the stock prices. It has also attracted more investors in the global market thus boosting the markets efficiency through proper price formation occurring due to the increased participation. (Hamilton, 1994) References Cheremza, W. and Derek, F. (1997): New direction in Econometric Practice, London Edward Elgar Hamilton, J. (1994): Time Series Analysis, Princeton, Princeton University Press. Hendry, D. (1999) Does Money determines UK Inflation in the Longrun Oxford, Nuffied College Obstfeld, M. and Kenneth, R. (1996): Foundation of International Macroeconomics, Cambridge, MIT Press Read More