Modeling and control for foreign exchange based on a continuous time stochastic microstructure model

On the basis of the market microstructure theory, a continuous time microstructure model is proposed for describing the dynamics of the foreign currency exchange time series with randomness and volatility features. From the microstructure model one may obtain the estimates of two state variables, which represent the market excess demand and liquidity respectively, but can not be directly observed. Based on the indirectly obtained excess demand information instead of the prediction of price, an asset dynamic allocation approach is investigated. The local linearization method, nonlinear Kalman filter and maximum likelihood method based estimation approach for the microstructure model proposed are also presented. A case study on the Japanese Yen/US Dollar exchange rate time series modeling and the estimated model-based asset dynamic allocation control show satisfactory modeling precision and control performance.