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

Sirimon Treepongkaruna*, Tim Brailsford, Stephen Gray

*Corresponding author for this work

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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.

Original languageEnglish
Pages (from-to)573-591
Number of pages19
JournalAustralian Journal of Management
Volume39
Issue number4
DOIs
Publication statusPublished - 24 Nov 2014

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