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

27 Pages Posted: 9 Sep 1998  

Roger D. Huang

University of Notre Dame

Ronald W. Masulis

University of New South Wales - Australian School of Business; European Corporate Governance Institute (ECGI); Financial Research Network (FIRN); National University of Singapore (NUS) - Asian Bureau of Finance and Economic Research (ABFER)

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 Classification: F31, G12, G14

Suggested Citation

Huang, Roger D. and Masulis, Ronald W., FX Spreads and Dealer Competition Across the 24-Hour Trading Day. Review of Financial Studies, Vol. 12, No. 1, pp. 61-93, Spring 1999. Available at SSRN: https://ssrn.com/abstract=122748

Roger D. Huang (Contact Author)

University of Notre Dame ( email )

Mendoza College of Business
Notre Dame, IN 46556-5646
United States
574-631-6370 (Phone)

Ronald W. Masulis

University of New South Wales - Australian School of Business ( email )

Sydney, NSW 2052
Australia
612-9385-5860 (Phone)
612-9385-6347 (Fax)

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

National University of Singapore (NUS) - Asian Bureau of Finance and Economic Research (ABFER) ( email )

BIZ 2 Storey 4, 04-05
1 Business Link
Singapore, 117592
Singapore

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