The interaction between the frequency of market quotations, spread and volatility in the foreign exchange market

Abstract

There is an empirical relationship between volatility, average spread, and number of quotations in the foreign exchange spot market. The estimation procedure involves two steps. In the first one the optimal functional form between these variables is determined through a maximization procedure of the unrestricted VAR, involving the Box—Cox transformation. The second step uses the two-stage least squares method to estimate the transformed variables in a simultaneous equation system framework. The results indicate that the number of quotations successfully approximates activity in the spot market. Furthermore, the number of quotations and temporal dummies reduce significantly the conditional heteroskedasticity e⁄ect. We also discuss information aspects of the model as well as its implications for financial informational theories. Inter- and intra-day patterns of the three variables are also revealed.