Foreign exchange market bid-ask spread and market power in an underdeveloped economy

Title Foreign exchange market bid-ask spread and market power in an underdeveloped economy
Author Tarron Khemraj, Sukrishnalall Pasha
Years  January 2000 to December 2007


Theoretical Basis This paper investigates the determinants of the persistent bid-ask spread in the Guyanese foreign exchange market. The large literature that focuses on bid-ask spread concentrates on either equity markets or foreign exchange markets in the advanced developed economies and the large developing and emerging economies.

This paper introduces the notion of market power in determining the spread and therefore ultimately the nominal exchange rate. Dealer market power would be important in economies with nascent flexible exchange rate regimes. Especially those underdeveloped economies that have implemented since the late 1980s market-based reforms in the financial sector in general and the FX market in particular.

Methods and Subjects This methodology, which is used extensively in cross-sectional studies that examines stock returns, was adopted in this paper owing to the availability of granular data on the trade of foreign currency in Guyana.
Main Result As a robustness check, we divide our sample into two equal non-overlapping periods and aggregate the coefficients using the methodology that was described. The results are not significantly different from those we obtain from looking at the entire sample period. The BAS is also positively and significantly related to MKP. The same can be said for the volatility in the level of transaction during the current and past periods. Also, the magnitudes of the slope coefficients are not significantly different between the two sub-periods.
Conclusion In this paper we used the GLS methodology to ascertain the factors that determine the BAS of the G$/US$ exchange rate. We found that the spread is affected by the volatility in the level of transactions during the current and past period. In particular, the evidence suggests that higher volatility leads to higher spread. We also uncovered a significant positive relationship between MKP (the proxy for market power) and the spread. This is an indication that there is segmentation in the foreign exchange market, whereby large cambios (the commercial banks) are able to set higher spreads and consequently dictate the nominal exchange rate.



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