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The purpose of this thesis is to shed more light in the FX market microstructure by examining the determinants of bid-ask spread for three currencies pairs, the US dollar/Japanese yen, the British pound/US dollar and the Euro/US dollar in different time zones. I examine the commonality in liquidity with the elaboration of FX market microstructure variables in financial centres across the world (New York, London, Tokyo) based on the quotes of three exchange rate currency pairs over a ten-year period. I use GARCH (1,1) specifications, ICSS algorithm, and vector autoregression analysis to examine the effect of trading activity, exchange rate volatility and inventory holding costs on both quoted and relative spreads. ICSS algorithm results show that intraday spread series are much less volatile compared to the intraday exchange rate series as the number of change points obtained from ICSS algorithm is considerably lower. GARCH (1,1) estimation results of daily and intraday bid-ask spreads, show that the explanatory variables work better when I use higher frequency data (intraday results) however, their explanatory power is significantly lower compared to the results based on the daily sample. This suggests that although daily spreads and intraday spreads have some common determinants there are other factors that determine the behaviour of spreads at high frequencies. VAR results show that there are some differences in the behaviour of the variables at high frequencies compared to the results from the daily sample. A shock in the number of quote revisions has more effect on the spread when short term trading intervals are considered (intra-day) compared to its own shocks. When longer trading intervals are considered (daily) then the shocks in the spread have more effect on the future spread. In other words, trading activity is more informative about the future spread when intra-day trading is considered while past spread is more informative about the future spread when daily trading is considered.

The foreign exchange (FX) market is the largest and most liquid financial market in the world. Like the centre of a spider web, the foreign exchange market connects to all other financial markets around the world. It is a global network that allows its participants to trade 24 hours 5 days a week from different geographical locations. Given this unique nature of the FX market, millions of daily tick data, referred to as high frequency data (HFD), are generated as a result of market participants' decisions and interactions. To understand market dynamics, our approach is to explore t~e microscopic world of the FX market by analysing in depth the millions of daily tick-by-tick prices and the micro-behaviour of FX participants, which in turn formulate a collective market macro-behaviour. This thesis conducts its analysis using an event-based approach. Events are actions taken by traders in the market. We carry out three studies with the aim to get an insight into how these events drive the FX market. V·hth these studies, we aim to make general inferences about market behaviour. The first two studies are empirical research based on analysing a unique high frequency real transaction data set of FX traders, whereas the third study formalises the market micro-dynamics. To prepare for our empirical studies, we have produced, to the best of our knowledge, the biggest set of HFD ever, which comprises tick transactions carried out by over 45,000 FX traders on an account level for over 2 years. In addition to cleaning the data set from any erroneous observations and ,,-a1idat ing the quality of the data, we provide strong indicators that the data set is representative of the of the global FX market. This confirms the reliability and validity of this research results. This data set is invaluable to·future researchers. The first empirical study tracks and analyses the FX market seasonal activity from a microscopic perspective, using the tick transactions of the HFD produced. We provide empirical evidence that the unique signature of the FX market seasonality is indeed due to the different time zones market participants operate from. However, once normalised using' our custom-designed procedure, we observe a pattern akin to equity markets. Thus, we have revealed an important FX market property that has not been reported before. The second empirical study conducts a microscopic analysis of FX market activity of the produced q.ata. set along price movement Given the high frequency and irregular nature of FX tick data, we adopt an intrinsic time scale approach proposed by Olsen Ltd. Intrinsic time is defined by exchange rate turning points of a pre-specified threshold, which are called directional change events. We provide empirical evidence for decaying market liquidity and price ticks changes at the end of the price movement, the overshoot period. \Ve find that a price overshoot stops due to more participants placing counter trend trades. The overshoot period is of special importance as it measures the excess price move of a given threshold and indicates the extent of imbalance in the market for the specified threshold. To our knowledge, this is the first study that deciphers FX market activity during price overshoots. It lays the foundations for understanding how FX market activity changes as the price movement progresses and how small imbalances of market activity in large overshoots can alter the price trajectory. The third study formalises market dynamics using calculus. In this approach, we define the different market states mathematically and demonstrate the consequence8 of placing an order into the market. This calculus enables us to analyse market dynamics and properties scientifically. For example, it allows us to study feedback loops, which account for the full effects of cascading margin calls. It also allows us to compute how big a sell order has to be to cause the market to fall by a certain percentage in a simple double auction market model. This work demonstrates how market dynamics and properties can be studied rigorously. It lays a solid foundation for extensive 8cientific analysis of complex market models.

This thesis brings together a number of studies using high frequency foreign exchange (FX) data. The first part examines the effects of scheduled, publicly released macroeconomic news, while the final chapter considers another, related, aspect of FX microstructure. Chapter 1 provides an introduction to the thesis and reviews the literature in high frequency empirical FX research. In Chapter 2, I use up to ten months of FX transactions and quote data to analyse foreign exchange activity around times of scheduled news releases. The effects of news on exchange rate levels are examined, as well as the effects on spreads, trading volume and volatihty. Chapter 3 extends this analysis, asking how public information enters prices. Under rational expectations and efficient markets hypotheses, the news contained in public information announcements should be impounded directly, with there being no role for trades in this process of information assimilation. However, the results suggest that up to two thirds of the price relevant information enters via trading (order flow in particular). Chapter 4 provides an explanation why order flow is so important around public news releases and also examines the effects of news on market depths. In Chapter 5 I examine how much information is carried in trades by looking at the price impact of order flow when feedback trading is allowed. The model that is often used in the literature is proved to be misspecified when temporally aggregated data are employed and Chapter 5 introduces a method to estimate the otherwise unidentified model. Using impulse response functions, I show that trades actually carry more information than previous estimates suggest.

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This thesis empirically assesses exchange rate volatility given the choice of exchange rate regimes and the responses of current account components (trade balance and net investment income flows) to exchange rate fluctuations across countries. Chapter 1 presents the general motivations of this thesis, followed by the research aims and methodology. The structure of thesis is then outlined. Chapter 2 investigates exchange rate volatility given the choice of exchange rate regimes. By assessing a large currency-pair sample over 1999M1-2006M12, bilateral exchange rate volatility increases with the degree of the flexibility of the exchange rate regime combinations. Currency network effects (i.e. pegs sharing the same anchor would benefit lower exchange rate volatility) are significant, with the structural variables also being controlled. Relative to the both-free-floating pairs, the marginal volatility-stabilising effects are identical across the anchors (networks) and hence the network effect increases with the network size. Managed floats are shown to track the US dollar, which consequently increases the effective size of the USD network relative to the others. Structural factors, such as larger cycle asymmetry, lower bilateral trade openness, larger economy size and per capita land resources, are associated with greater bilateral exchange rate volatility. Inflation conditions significantly undermine the network effects. Moreover, the volatility-stabilising effects increases with the peg network size under the arithmetic multilateral exchange rate volatility measure but not under the trade-weighted measure, indicating the competing rationales for the choice of anchors (networks). Chapter 3 assesses the trade balance adjustments in response to exchange rate fluctuations across countries. By estimating fixed-effects regressions covering 96 countries from 1993 to 2006, trade balance exhibits significant responses for the contemporaneous and the subsequent one year, particularly for the Industrial and Emerging Market groups. The J-curve dynamics become more evident after exports and imports are examined separately. There are clear asymmetric patterns between the Industrial and developing economies. The latter group tends to have larger and more instant adjustments both on trade balance and between tradable and nontradable sectors than the former. Moreover, the Industrial economies on average show symmetric long-run and short-run responses to depreciations and appreciations. However, the Emerging Market economies’ trade balance tend to respond faster to depreciations than to appreciations. Relative to the moderate degree of fluctuations, large exchange rate changes for developing economies are associated with the inverse dynamics of the normal cases. Other factor variables, such as the terms of trade and domestic income variables exhibit explanatory power as expected in the literature. By taking fixed-effects regressions over a similar sample to Chapter 3, Chapter 4 examines the changes of net investment incomes in response to exchange rate fluctuations across countries with different foreign currency lending positions. Given the initial net capital outflow, depreciations (appreciations) are associated with net investment income improvements (deteriorations) for the Industrial economies, most of which have positive positions of foreign currency exposure (FXE), i.e. foreign currency assets exceed liabilities. An inverse case applies for the developing economies of which most possess negative positions of FXE. Given the changes of exchange rate, the degree of this valuation effect increases with the imbalance position of FXE particularly among the Industrial and Emerging Market economies. Further investigations show that this is mainly driven by the adjustments of foreign currency components in the two groups’ external balance sheets. For the other developing economies, there are insignificant valuation effects conditioning on the FXE positions that are mainly driven by the overall net foreign borrowing positions. The initial captial outflow proxied by the lagged current account position tends to have insignificant effects on the net investment income flows across the countries. Combing the trade balance dynamics and the valuation effects, the overall current account adjustments are mainly driven by the trade balance across the economies. Given similar long-run quantitative effects of exchange rate fluctuations between the Industrial and Emerging Market economies, the latter group exhibits faster and larger short-run trade balance and current account responses than the former. The valuation effects are insignificant in the overall current account adjustments. Nevertheless, the valuation effects tend to counteract the trade balance adjustments for the Emerging Market economies given an exchange rate change, while those two channels work in the same direction for the Industrial economies. These asymmetries further indicate the importance of country’s external portfolio dynamics. Chapter 5 summarises the main findings, followed by the discussions about implications and possible future research.

This thesis investigates the price discovery in the foreign exchange market using high frequency data. Traditional exchange rate models assume market homogeneity and the sole existence of public information. However. recent studies suggest such assumptions are not well founded and have generated the 'disconnection' puzzle of exchange rates deviating from their fundamentals in the short and medium term. Using EFX tick-by-tick data, we find that information is not always available to all and the actual price discovery process is dynamic and asymmetric. It suggests that some market participants, trading systems or even exchange rates may possess private information. which helps them to lead others in finding the equilibrium prices. It further reveals the importance of studying the microstructure of the foreign exchange market, which may in the future solve the 'disconnection' puzzle that has baffled the exchange rate theory for the past decades.

The recent slowdown in global economic activity has shown that macroeconomic models without a well-structured representation of the financial sector will fail to provide understanding of the way that disruptions in credit markets, capital markets and banking can affect the rest of the economy. An investigation of foreign exchange speculation is used to get a better knowledge of the interaction between the financial sector and the economy as a step towards improving macroeconomic models and policy. The first part of this research looks at speculation at the macroeconomic level by using a structured vector auto regression (SVAR) to assess the relationship between capital flows and the US real exchange rate. The second assesses whether speculation can be used to identify price reversals in foreign exchange markets. The final section seeks to understand more about speculative risk with a detailed analysis of uncovered interest parity and the speculative attempt to take advantage of times when it does not hold. Speculative activity is a significant contributor to changes in the real exchange rate. No informational content is found in the extremes of speculative activity but it is shown that speculators are compensated for taking crash risk and that their activity may increase the amount of crash risk in the markets where they are operating. The main contributions of this work are applying a microstructure approach at the macro level; adding speculation to a model of international capital flows; the use of a unique series of options data to identify speculative sentiment; using a carry trade model to understand more about uncovered interest parity and the returns to speculation; using the event study method to investigate speculative extremes; and using all this to suggest ways to improve macroeconomic models and policy.

L'objectif de cette thèse est double. Premièrement, elle vise à proposer une revue de la littérature économique s'intéressant à l'exposition au taux de change de la profitabilité des entreprises non-financières, et à fournir de nouveaux enseignements sur son hétérogénéité intra et inter-sectorielle. Deuxièmement, cette thèse analyse les stratégies de production et de produits mises en œuvre par les firmes pour se prémunir des effets de ces variations de change. Puisque l'éventail de telles stratégies est large, le dernier chapitre se concentre sur la stratégie de montée en gamme. / This thesis follows a dual objective. First, it aims to summarize previous evidence on the magnitude and channels underpinning a non-financial firm’s operating exposure, i.e. the extent to which currency fluctuations can alter a company's future operating cash flow, and to provide new highlights on the heterogeneity of this exposure across firms. Second, this thesis investigates the product and production strategies that are appropriate for coping with the economic consequences of exchange rate changes on firms’ operating profits. Since the range of these strategies is large, it focuses on providing theoretical and empirical evidence for the strategy of up-market positioning.