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

Sirimon Treepongkaruna, Tim Brailsford and Stephen Gray
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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

Australian Journal of Management, 2014, vol. 39, issue 4, 573-591

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.

Keywords: Bid-ask spread; foreign exchange; inventory-holding premium; microstructure (search for similar items in EconPapers)
JEL-codes: D23 F23 F31 G12 G13 G14 G15 (search for similar items in EconPapers)
Date: 2014
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Persistent link: https://EconPapers.repec.org/RePEc:sae:ausman:v:39:y:2014:i:4:p:573-591

DOI: 10.1177/0312896213499028

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