Parameter Stability in Foreign Exchange Market Microstructure

Microstructure models of foreign exchange markets emphasize two different channels of pressure in pricing dynamics; these are inventory and asymmetric information effects. Past empirical studies for foreign exchange markets have found evidence supporting the existence of both effects in the Dollar/DM market. This paper tests for the presence of within sample variation in the intensity of these effects and whether these are related to market conditions external to the pricing agent (the dealer). We test for and find multiple structural changes at conventional significance level. We incorporate the parameter instability into the estimated equations of foreign exchange. The new estimates reveal a pattern in which asymmetric information effects and inventory effects on the price of foreign exchange vary in intensity with external market conditions, and are dependent on these conditions. ∗ Department of Economics, University of Maryland 20742-7311; [email protected]; 301.484.1588.