Arbitrageur, Speculator, and Liquidity Trader: A Behavioral Spot Exchange Rate Model

This study builds a model of spot exchange rate determination based on the specifics of market activities from an explicitly micro perspective. Given the net position of liquidity traders, this paper examines the interaction of the behavior of two different camps in the foreign exchange market: the arbitrageurs and the speculators. The model is cast in a flexible framework so that it can explain a variety of exchange rate regimes, ranging from the floating to the fixed rate systems. With elaborate specifications on the behavior of arbitrageurs, the model is especially suitable for probing the operations of the gold standard and variations of currency board arrangements (CBAs), both of which are heavily dependent on arbitrage efficiency in locking the spot exchange rate. Finally, this paper also has implications for studying the determinants of the exchange rates of crypto currency against official currency such as the US dollar. Since crypto currency markets are operated in a decentralized environment, the equilibrium spot exchange rates are entirely dependent on the market mechanisms. With appropriate modifications, the analytical framework of this study could be adapted to explore cryptocurrency markets in future research.