| Despite a well-established literature on market microstructure and a growing interest in the (very) short-term empirical behavior of flexible exchange rates, the effect of market microstructure on the operational efficiency of the market is not well understood. This thesis examines the potential efficiency gains to the foreign exchange market from changes in market composition, defined by the numbers of market-makers, brokers and customers active in the market.;A detailed model of the U. S. foreign exchange market, involving heterogeneous market-makers, brokers and customers is developed. Market-makers take speculative inventory positions, and include observed price information in subjective price distributions. News arrives in the marketplace at random via a Poisson process. News arrivals are treated as regime shifts which reset the subjective distributions to new priors. Using a computer simulation, the model is systematically validated with real-world data on intradaily prices and market volume for April of 1989. Given this, data on market inefficiency in the very short run (i.e., intraday) are generated.;With this as given, the number of market-makers, brokers, and customers, and the arrival rate of unanticipated news events are varied as experimental variables, and the resulting inefficiency is assessed. The types of inefficiency considered in this thesis differ substantially from the traditional notion of price efficiency. Five measures of operational inefficiency are defined: the number of arbitrage opportunities, the number of transactions occurring away from the market spread, the time required to converge to a price consensus in the absence of news arrivals, the average deviation of market-maker inventories from their optimal (i.e., desired) levels, and the degree of serial correlation in prices.;The experimental technique employed is a full-factorial response surface design over these four experimental variables. The results reveal a significant and complex relationship between market inefficiency and market composition. Much of the inefficiency present can be explained by temporary inventory imbalances for individual market-makers resulting from the decentralized nature of the market. One implication of such a conclusion is that a fundamental change in foreign exchange market microstructure which centralizes trading could do much to attenuate such inefficiencies. |
