Exchange rate dynamics: an approach based on market microstructure theory

This article examines the dynamics of the nominal exchange rate in Peru using a theoretical framework based on market microstructure theory, with a particularly focused examination of the flow of buy and sell orders in the interbank market. The research focuses on how variations in order flow, market makers’ inventory management, and external factors—such as the behavior of the Brazilian real—influence the determination of the exchange rate. Using daily data from January 2000 through November 2002, the study estimates a VAR model that provides empirical evidence on the relationship between order flow and the exchange rate, finding that order flow has a significant and contemporaneous impact on price adjustments. The results indicate that an increase in net foreign currency purchases leads to a depreciation of the exchange rate in the following days, suggesting the importance of considering market microstructure in the analysis of exchange rate policy and risk management. (Abstract and audio: Department of Economic Publications)