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Foreign exchange market bid-ask spread and market power in an underdeveloped economy

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  • Khemraj, Tarron
  • Pasha, Sukrishnalall

Abstract

This paper explores the influence of trader (or cambio) market power in determining the foreign exchange market bid-ask spread. In particular, it presents a theoretical model that incorporates the notion of oligopolistic power into the foreign exchange market. The econometric analysis substantiates the existence of oligopolistic trader market power in determining the spread. Moreover, the results confirm the prediction of standard market microstructure theory that volatility exerts a positive effect on spread. We also uncovered a positive relationship between liquidity (the quantity of foreign exchange traded) and spread, a result which differs from the existing literature. We interpret this finding to mean that oligopolistic traders set the mark-up exchange rate above where the purely competitive rate would have been so as to generate a surplus of US$ that is then hoarded. The econometric exercise utilizes a unique data set of trading volumes and buying/selling exchange rates for each cambio from January 2000 to December 2007.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 11422.

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Date of creation: Oct 2008
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Handle: RePEc:pra:mprapa:11422

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Keywords: bid-ask spread; foreign exchange market; GLS;

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References

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  1. Alexander Mende, 2006. "09/11 on the USD/EUR foreign exchange market," Applied Financial Economics, Taylor & Francis Journals, vol. 16(3), pages 213-222.
  2. Bollerslev, Tim & Melvin, Michael, 1994. "Bid--ask spreads and volatility in the foreign exchange market : An empirical analysis," Journal of International Economics, Elsevier, vol. 36(3-4), pages 355-372, May.
  3. Datar, Vinay T. & Y. Naik, Narayan & Radcliffe, Robert, 1998. "Liquidity and stock returns: An alternative test," Journal of Financial Markets, Elsevier, vol. 1(2), pages 203-219, August.
  4. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
  5. Tarron Khemraj, 2008. "Excess liquidity, oligopolistic loan markets and monetary policy in LDCs," Working Papers 64, United Nations, Department of Economics and Social Affairs.
  6. Boothe, Paul M, 1988. "Exchange Rate Risk and the Bid-Ask Spread: A Seven Country Comparison," Economic Inquiry, Western Economic Association International, vol. 26(3), pages 485-92, July.
  7. 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.
  8. Tarron Khemraj, 2009. "Excess liquidity and the foreign currency constraint: the case of monetary management in Guyana," Applied Economics, Taylor & Francis Journals, vol. 41(16), pages 2073-2084.
  9. 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.
  10. Becker, Torbjorn & Sy, Amadou, 2006. "Were bid-ask spreads in the FX market excessive during the Asian crisis?," International Review of Financial Analysis, Elsevier, vol. 15(4-5), pages 434-449.
  11. Brennan, Michael J. & Subrahmanyam, Avanidhar, 1996. "Market microstructure and asset pricing: On the compensation for illiquidity in stock returns," Journal of Financial Economics, Elsevier, vol. 41(3), pages 441-464, July.
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Cited by:
  1. Gurnain Kaur Pasricha, 2009. "Bank Competition and International Financial Integration:Evidence Using a New Index," Working Papers 242009, Hong Kong Institute for Monetary Research.

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