Bid-ask Spread and Order Size in the Foreign Exchange Market: An Empirical Investigation

Title Bid-ask Spread and Order Size in the Foreign Exchange Market: An Empirical Investigation
Author Liang Ding
Years 2006

 

Theoretical Basis Financial theory has identified three basic sources of bid-ask spreads: order processing costs, inventory holding risks, and information costs of market making.

In summary, various models provide mixed predications of the relationship between spread and order size. Which candidate model is correct? How is order size related to spread in the real world?

Methods and Subjects The data used in this paper were collected from an online foreign exchange dealer. This dealer displayed both customer and inter-bank bid-ask quotes for several major currencies on its quotes window in response to individual quote requests randomly generated by a computer program. The dealer’s responses – its bid-ask quotes – become part of my dataset. This paper focused on the rate of the US dollar versus the Euro (USD/EUR), currently the most frequently traded currency pair in the world.
Main Result This claim seems consistent with both intuition and reality. In the FX market, dealers first obtain information from customer order flow. This information then spreads in the market through inter-dealer trading. So, dealers have more incentive to reduce spread to attract large orders in the customer market than in the inter-dealer market. Therefore, the strategic trading effect is likely stronger in the customer market.
Conclusion This article empirically examines the relationship between order size and spread in the foreign exchange market. Based on quotes from an individual FX dealer, spread appears to be independent of order size in the inter-dealer market, while the two are negatively correlated in the customer market. None of the current models can explain this finding alone, so new models are needed to provide more convincing theoretical reasoning.

 

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