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Explaining the bid-ask spread in the foreign exchange market: A test of alternate models

Author

Listed:
  • Sirimon Treepongkaruna

    (UWA Business School, The University of Western Australia, Australia)

  • Tim Brailsford

    (Bond University, Australia)

  • Stephen Gray

    (UQ Business School, University of Queensland, Australia)

Abstract

This paper attempts to uncover the determinants of the dealer bid-ask spread in the foreign exchange market. Prior research has examined the Huang–Masulis model wherein the spread is modelled as a function of dealer competition and volatility. We first extend this model to a much larger set of quote data covering several currencies over five years. A more recent model of the bid-ask spread has been proposed (BSW) wherein the spread is modelled as a function of order-processing costs, inventory-holding costs, adverse selection and competition. This model has not previously been tested in the foreign exchange market and this study conducts such a test. We find general support for both models using individual currency samples and a pooled sample. Of note, we find strong evidence for the relevance of the inventory-holding premium on the size of the dealer bid-ask spread. To compare the two models we undertake out-of-sample forecasts of the spread and find evidence that favours the BSW model in the aggregated sample, while the evidence is mixed in relation to individual currencies.

Suggested Citation

  • Sirimon Treepongkaruna & Tim Brailsford & Stephen Gray, 2014. "Explaining the bid-ask spread in the foreign exchange market: A test of alternate models," Australian Journal of Management, Australian School of Business, vol. 39(4), pages 573-591, November.
    • Handle: RePEc:sae:ausman:v:39:y:2014:i:4:p:573-591
    DOI: 10.1177/0312896213499028
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    References listed on IDEAS

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    More about this item

    Keywords

    Bid-ask spread; foreign exchange; inventory-holding premium; microstructure;
    All these keywords.

    JEL classification:

    • D23 - Microeconomics - - Production and Organizations - - - Organizational Behavior; Transaction Costs; Property Rights
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • F23 - International Economics - - International Factor Movements and International Business - - - Multinational Firms; International Business
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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