Explaining the Bid-Ask Spread in the Foreign Exchange Market: A Test of Alternate Models

Posted: 14 Nov 2014

See all articles by Sirimon Treepongkaruna

Sirimon Treepongkaruna

The University of Western Australia; Financial Research Network (FIRN)

Tim Brailsford

Bond University

Stephen Gray

University of Queensland - Business School; Duke University - Fuqua School of Business; Financial Research Network (FIRN)

Date Written: November 13, 2014

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

Suggested Citation

Treepongkaruna, Sirimon and Brailsford, Timothy John and Gray, Stephen, Explaining the Bid-Ask Spread in the Foreign Exchange Market: A Test of Alternate Models (November 13, 2014). Australian Journal of Management, Vol. 39, No. 4, 2014. Available at SSRN: https://ssrn.com/abstract=2523912

Sirimon Treepongkaruna (Contact Author)

The University of Western Australia ( email )

35 Stirling Highway
Crawley, Western Australia 6009
Australia
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+61864881086 (Fax)

Financial Research Network (FIRN)

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

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

Timothy John Brailsford

Bond University ( email )

Gold Coast, QLD 4229
Australia

HOME PAGE: http://www.bond.edu.au

Stephen Gray

University of Queensland - Business School ( email )

University of Queensland
Brisbane, Queensland 4072
Australia

Duke University - Fuqua School of Business

Box 90120
Durham, NC 27708-0120
United States

Financial Research Network (FIRN) ( email )

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

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