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

Liang Ding
Department of Economics, Macalester College

Abstract:

This article empirically examines the relationship between order sizes and spreads in the foreign exchange market based on a FX dealer’s quotes. It is found that spreads are independent of order sizes in the inter-dealer market, but they are negatively correlated in the customer market.

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I focused on the rate of the USdollar versus the Euro (USD/EUR), currently the most frequently traded currency pair in the world.

To obtain quotes for large, medium and small orders, the program selected order size based on the normal distribution around $5,000,000, $500,000, and $10,000 respectively. The sample generally contained similar numbers of large, medium and small sizes. I used each order size for five times at the interval of one minute. Every five-minutes, I switched to a different order size.

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Looking back at the existing models surveyed in Section 2, it seems that only the processing cost model can explain the negative relationship between order size and customer spread.

In addition, as suggested by Osler et. al. (2006), the negative pattern can also be supported by another important spread determinant in the FX market – strategic dealing. Building on abundant evidence that order flow carries information (e.g., Evans and Lyons 2002), the paper argues that rational FX dealers might strategically vary spreads to gain information that they can then exploit in future trades.

Thus, FX dealers effectively subsidize spreads to attract those larger transactions most likely to carry useful information.

On the other hand, inventory risk and adverse selection might not be as significant as predicted by theories in this dealer’s spread determination.

Inventory risk is associated with the dealer’s unexpected inventory change. When this dealer receives such a change, it can adjust its inventory and share the risk with other dealers through inter-dealer trading quickly and easily.

With regard to asymmetric information, Bjønnes and Rime (2005) suggest that instead of order size, it is only the direction of an order that carries information, and this paper presents evidence consistent with this alternative hypothesis. Therefore, spreads could be unrelated to order size even under adverse selection either.

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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 thecustomer market.

Information Flows in Dark Markets: Dissecting Customer Currency Trades

by Lukas Menkhoff, Lucio Sarno, Maik Schmeling and Andreas Schrimpf

Bank for International Settlements, March, 2013


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This paper empirically addresses three related questions to improve our understanding of the ecology of the world's largest financial market, the FX market.

First, given that the FX market is fairly opaque with a large concentration of market making in the hands of a few large intermediaries, how valuable is it for dealers to observe a large proportion of the market's order flow?

Second, do FX end-users share risks among themselves, or is their trading highly correlated and unloaded to the dealers and the inter-dealer market? Third, how can we understand the trading behavior, trading styles and risk exposures of various key players in FX markets, and how is this linked to risk sharing?

We find that observing customer order flows in a dark market is highly valuable from the dealer's perspective. Currency excess returns to portfolios mimicking aggregate customer order ows in real-time are about 10% p.a. and highly signicant. In addition, trading in FX markets (as in other OTC markets) is anonymous, meaning that dealers know the identity of their clients. Incorporating this feature into our setup, we nd excess returns as high as 15% p.a., that is, non-anonymity further increases the informational advantage of dealers.

The flows by asset managers have the strongest predictive power for exchange rates, likely reacting the processing of fundamental information. Their flows have a permanent forecast power, whereas flows originating from the other groups only predict transitory changes of exchange rates.

All this suggests that dealers have a strong incentive to gain large market shares (besides other reasons such as economies of scale in the provision of trading infrastructure, for example) and to set up trading in a way that reveals end-users' identities.

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VirtuaGod Escreveu:link plz

Edit:_ Já estou a ficar comoo as pessoas que menos gosto (quem não pesquisa no google) http://cadmus.eui.eu/bitstream/handle/1814/17582/ECO_2011_23.pdf?sequence=1

The multiscale causal dynamics of foreign exchange markets

2013

Stelios Bekiros and Massimiliano Marcellino

European University Institute, Department of Economics

ABSTRACT

This paper relies on wavelet multiresolution analys is to capture the dependence structure of currency markets and reveal the complex dynamics across different timescales.

It investigates the nature and direction of causal relationships among the most widely traded currencies denoted relative to the United States Dollar (USD), namely Euro (EUR), Great Britain Pound (GBP)and Japanese Yen (JPY). The timescale analysis involves the estimation of linear vis-à-vis nonlinear and spectral causality of wavelet components and aggregate series as well as the detection of short- vs. long-run linkages and cross-scale correlations.

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Overall, the results strongly indicate that interactions between currency markets have different characteristics at different timescales and that there is no “global causal behavior” that prevails at all time horizons. When the nonlinear effects are accounted for, neither FX market leadsor lags the other consistently, namely the pattern of leads and lags changes over time.

Given that causality can vary from one direction to the other, a finding of bidirectional causality over the sample period may be taken to imply a changing pattern of leads and lags over time.

In particular, market participants filter information relevant to their positions as new information arrives and, at any time point, one FX market may lead the other and vice versa.

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