FX Spreads and Dealer Competition Across the 24-Hour Trading Day

Abstract:     
This study examines the impact of changing dealer competition and order flow across the 24 hour day on bid-ask spreads in the foreign exchange (FX) market. Using one year of tick-by-tick data in the spot Deutschmark-Dollar FX market, trading information is aggregated into 15 minute intervals over the trading day. Dealer competition is approximated by the number of individual dealers revising their quotes in each 15 minute interval. Bid-ask spreads, dealer activity and volatility are jointly modeled in a 3 equation VAR system, taking into account major market microstructure theories of spread determination which focus on adverse selection risk and inventory costs. Model estimation is by GMM, and takes into account a rich set of seasonal patterns and strong serial correlation in the dependent variables. Consistent with market microstructure theory, bid-ask spreads decrease as predicted dealer activity rises and as predicted FX volatility falls. Dealer competition is strongly time-varying and highly predictable, reflecting changing business activity over the 24-hour trading day as major Asian, European and North American markets open and close. Model estimates show that an expected addition of another dealer lowers average quoted spreads by 1.7%, while a 10% rise in FX volatility raises average quoted spreads by 10%.

Keywords: Foreign Exchange, FX Trading, Market Microstructure Models, Tick-by-Tick Trades, 24 Hour Trading, Dealer Competition, Market Making, Dealer Market, Bid-Ask Spread, FX Volatility, VAR model, GMM

JEL Classifications: F31, G12, G14

Accepted Paper Series