Bid-Ask Spread Components on the Foreign Exchange Market: Quantifying the Risk Component

We study the tightness of the complete electronic interbank foreign exchange market for the HUF/ EUR over a two year period. First, we review the cost components that a liquidity provider on this type of market faces, and integrate them in an empirical spread decomposition model. Second, we estimate the bid-ask spread components on an intraday basis, and find that order processing costs account for 47.09% of the spread and that, the combined inventory holding and adverse selection risk component accounts for 52.52% of the spread. In addition, we provide evidence for an endogenous tick size that accounts for one third of the order processing costs and we also estimate the number of liquidity providers based on the risk component. Third, we apply the model to some interesting spread patterns. Using our model we investigate the stylized difference in spreads between peak-times and non-peak times. We find that the combined compensation for inventory holding and adverse selection risk increases during non-peak times, particularly because the risk that a liquidity provider will have to carry an inventory overnight rises. Furthermore, we apply the model to the interesting spread pattern around a speculative attack. Here, credibility of the exchange rate band, competition amongst liquidity providers and increased volatility are key in understanding what happens during this episode of extreme turmoil.