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Anticipations of Foreign Exchange Volatility and Bid-Ask Spreads

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  • Shang-Jin Wei

Abstract

The paper studies the effect of the market's perceived exchange rate volatility on bid-ask spreads. The anticipated volatility is extracted from currency options data. An increase in the perceived volatility is found to widen bid-ask spreads. The direction of the effect is consistent with an option model of the spread, but the magnitude is smaller. An increase in trading volume of spot exchange rates also widens the spread. The omission of the trading volume, however, does not bias the estimate of the effect of the volatility on the spreads. Although the spread-volatility relation implied by the option model of the spread is close to linear, some form of nonlinearity can still be detected from the data.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4737.

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Date of creation: May 1994
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Handle: RePEc:nbr:nberwo:4737

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  1. Glosten, Lawrence R, 1987. " Components of the Bid-Ask Spread and the Statistical Properties of Transaction Prices," Journal of Finance, American Finance Association, American Finance Association, vol. 42(5), pages 1293-1307, December.
  2. David S. Bates, . "Pricing Options Under Jump-Diffusion Processes," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 37-88, Wharton School Rodney L. White Center for Financial Research.
  3. Glassman, Debra, 1987. "Exchange rate risk and transactions costs: Evidence from bid-ask spreads," Journal of International Money and Finance, Elsevier, Elsevier, vol. 6(4), pages 479-490, December.
  4. Richard K. Lyons, 1986. "Tests of the foreign exchange risk premium using the expected second moments implied by option pricing," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 290, Board of Governors of the Federal Reserve System (U.S.).
  5. Black, Stanley W., 1991. "Transactions costs and vehicle currencies," Journal of International Money and Finance, Elsevier, Elsevier, vol. 10(4), pages 512-526, December.
  6. Richard K. Lyons., 1993. "Tests of Microstructural Hypotheses in the Foreign Exchange Market," Research Program in Finance Working Papers, University of California at Berkeley RPF-230, University of California at Berkeley.
  7. Jeffrey A. Frankel, 1993. "On Exchange Rates," MIT Press Books, The MIT Press, The MIT Press, edition 1, volume 1, number 0262061546, December.
  8. Melvin, Michael & Tan, Kok-Hui, 1996. "Foreign Exchange Market Bid-Ask Spreads and the Market Price of Social Unrest," Oxford Economic Papers, Oxford University Press, vol. 48(2), pages 329-41, April.
  9. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
  10. Boothe, Paul M, 1988. "Exchange Rate Risk and the Bid-Ask Spread: A Seven Country Comparison," Economic Inquiry, Western Economic Association International, Western Economic Association International, vol. 26(3), pages 485-92, July.
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Cited by:
  1. Alexander Mende, 2006. "09/11 on the USD/EUR foreign exchange market," Applied Financial Economics, Taylor & Francis Journals, Taylor & Francis Journals, vol. 16(3), pages 213-222.
  2. Detken, Carsten & Hartmann, Philipp, 2000. "The Euro and International Capital Markets," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2461, C.E.P.R. Discussion Papers.
  3. David C. Parsley & Shang-Jin Wei, 1994. "Insignificant and Inconsequential Hysteresis: The Case of the U.S. Bilateral Trade," NBER Working Papers 4738, National Bureau of Economic Research, Inc.
  4. Geir Hoidal Bjonnes & Dagfinn Rime & Haakon O. Aa. Solheim, 2003. "Volume and Volatility in the FX Market: Does it matter who you are?," Working Paper, Norges Bank 2003/7, Norges Bank.
  5. Shang-Jin Wei & Jeffrey A. Frankel, 1991. "Are Option-Implied Forecasts of Exchange Rate Volatility Excessively Variable?," NBER Working Papers 3910, National Bureau of Economic Research, Inc.
  6. Detken, Carsten & Hartmann, Philipp, 2000. "The euro and international capital markets," CFS Working Paper Series 2000/09, Center for Financial Studies (CFS).
  7. Gabriele Galati, 2000. "Trading volumes, volatility and spreads in foreign exchange markets: evidence from emerging market countries," BIS Working Papers 93, Bank for International Settlements.
  8. Törbjörn I. Becker & Amadou N. R. Sy, 2005. "Were Bid-Ask Spreads in the Foreign Exchange Market Excessive During the Asian Crisis?," IMF Working Papers 05/34, International Monetary Fund.

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