Title

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

Date of this Version

1-1-2014

Document Type

Journal Article

Publication Details

Citation only

Treepongkaruna, S., Brailsford, T.J., & Gray, S. (2014). Explaining the bid-ask spread in the foreign exchange market: A test of alternate models. Australian Journal of Management, 39(4), 573-591.

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© Copyright, The Author(s) 2013

2014 HERDC submission

ISSN

0312-8962

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.

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This document has been peer reviewed.