This special issue of the International Journal of Finance and Economics presents five papers from leading authors and practitioners on various aspects of foreign exchange market microstructure. The literature on market microstructure has grown rapidly in recent years. While traditional models have largely failed to provide a robust explanation of exchange rate behaviour during the floating rate era, the nascent microstructure literature has drawn a number of important lessons from recent experience. In particular, it is now widely accepted that an understanding of the short-term behaviour of exchange rates requires a keen understanding of the motives, opportunity sets and interaction of the various market participants.
The first paper in this special issue is by Martin Evans and Richard Lyons; the importance of their innovative and pioneering contributions to the market microstructure literature is well established and widely appreciated. In 'Understanding Order Flow', Evans and Lyons concentrate upon the ability of heterogeneous customer order flow from a major dealing bank to explain future exchange rate returns up to 1 month ahead. They conclude in favour of a significant relationship and rationalize this result primarily in terms of the ability of customer order flow}and particularly flow initiated by longer-term investors}to provide timely information to market-makers about the evolution of key fundamental variables. This information is an important determinant of the level of future dealer bid-ask quotes, and therefore exchange rate returns. Consistent with their hypothesis, Evans and Lyons report empirical findings that forecasting models able to exploit this heterogeneity on the basis of disaggregated flow data generate more accurate return forecasts than models that exploit only aggregated customer flow data.
In 'Explaining Trading Volumes in the Euro', Janusz Brzeszczynski and Michael Melvin examine the time series behaviour of traded volumes in euro-dollar since the inception of the single currency in January 1999 and until October 2003. They seek to explain a number of outstanding issues related to the path of traded volumes in this exchange rate, including the initial down trend in volumes and the subsequent partial recovery. Using weekly data, Brzeszczynski and Melvin conclude that the behaviour of momentum, or trend-following, investors was the primary explanatory factor of variations in weekly traded volumes during this period, while exploitation of so-called carry trades also had some relevance. Using daily data, Brzeszczynski and Melvin determine the presence of significant day-of-the-week effects for euro-dollar traded volumes. In addition, employing 5-minute tick data over the period January-October 2003, Brzeszczynski and Melvin demonstrate the importance of limit orders that concentrate on round numbers for the pattern of intra-day traded volumes.
The third paper in this issue is contributed by JoΒ΄n DanΔ±Β΄elsson and Ryan Love. 'Feedback Trading' considers the price impact of inter-dealer order flow taking into account a hypothesized positive contemporaneous feedback effect between flow and foreign exchange returns; namely, that order flow in a given trading period generates returns that subsequently trigger additional flow within the same trading