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Decomposing the bid-ask spread in multi-dealer markets

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  • Michael Bleaney
  • Zhiyong Li

Abstract

In this paper, we modify the Huang and Stoll (1997) spread-decomposing model to fit multi-dealer markets. In a multi-dealer market, individual dealers can rebalance their inventories either by trading with other dealers or changing the quote price. Our modified model captures this feature. Using transaction data from the Reuters D2000-1 system, we find that the order-processing and inventory control components of the spread in the foreign exchange market are relatively small and dealers may tolerate the unwanted inventory to keep the spread small to attract informed orders. The asymmetric information component carries the biggest weight. We study the time pattern of the spread and its components. The spread varies significantly with the time of day, but the inventory control and asymmetric information components do not.

Suggested Citation

  • Michael Bleaney & Zhiyong Li, 2014. "Decomposing the bid-ask spread in multi-dealer markets," Discussion Papers 14/03, University of Nottingham, School of Economics.
  • Handle: RePEc:not:notecp:14/03
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    References listed on IDEAS

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    1. Bjonnes, Geir Hoidal & Rime, Dagfinn, 2005. "Dealer behavior and trading systems in foreign exchange markets," Journal of Financial Economics, Elsevier, vol. 75(3), pages 571-605, March.
    2. McInish, Thomas H & Wood, Robert A, 1992. " An Analysis of Intraday Patterns in Bid/Ask Spreads for NYSE Stocks," Journal of Finance, American Finance Association, vol. 47(2), pages 753-764, June.
    3. Osler, Carol L. & Mende, Alexander & Menkhoff, Lukas, 2011. "Price discovery in currency markets," Journal of International Money and Finance, Elsevier, vol. 30(8), pages 1696-1718.
    4. Frank McGroarty & Owain ap Gwilym & Stephen Thomas, 2007. "The Components of Electronic Inter-Dealer Spot FX Bid-Ask Spreads," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 34(9-10), pages 1635-1650.
    5. S. Viswanathan & James J. D. Wang, 2004. "Inter-Dealer Trading in Financial Markets," The Journal of Business, University of Chicago Press, vol. 77(4), pages 987-1040, October.
    6. Lyons, Richard K., 1997. "A simultaneous trade model of the foreign exchange hot potato," Journal of International Economics, Elsevier, vol. 42(3-4), pages 275-298, May.
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    Keywords

    Bid-ask Spread; Multi-dealer Market; Decomposition JEL codes: G10; G15;

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