Abstract
AbstractIn this paper, we modify the Huang and Stoll spread‐decomposing model to fit multi‐dealer markets. In a multi‐dealer market, individual dealers can rebalance their inventories either by trading with other dealers or by changing the quote price. Our modified model captures this feature. Using transaction data from the Reuters D2000‐1 system, we find that the order‐processing and inventory control components of the spread in the foreign exchange market are relatively small and dealers may tolerate the unwanted inventory to keep the spread small to attract informed orders. The asymmetric information component carries the biggest weight. We study the time pattern of the spread and its components. The spread varies significantly with the time of day, but the inventory control and asymmetric information components do not. Copyright © 2015 John Wiley & Sons, Ltd.
Highlights
The bid-ask spread provides an important measure of trade costs and maree ket liquidity
We will refer to the new model as the modified HS model (MHS model thereafter)
Hot-potato trading ev to reduce inventory imbalances is ruled out by assumption in the HS model, but if it is prevalent trade direction will tend to be positively serially correlated, and this is what we find in data from the Reuters D2000-1 system
Summary
The bid-ask spread provides an important measure of trade costs and maree ket liquidity. The Huang and Stoll model (HS model) aims to estimate the bid-ask spread and to decompose it into its components, using information about transactions prices and trade direction. Lyons (1997) and Evans and Lyons (2002) emphasise that in the foreign exchange interdealer market, a quote-driven market, dealers exchange price information and control the inventory through hot potato trading, in which dealers make an order right after receiving an order in the same direction They use the second method to control the inventory. Assuming that the imbalance re-distribution process is efficient (k1 = 1), when the intolerable inventory is zero (k2 = 0) or there are infinite dealers in the market (N = ∞), the MHS model becomes.
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