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«Volume Title: The Microstructure of Foreign Exchange Markets Volume Author/Editor: Jeffrey A. Frankel, Giampaolo Galli, Alberto Giovannini, editors ...»

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15. For a detailed discussion of this approach, see Kleidon (1995). This general approach has been examined in the context of foreign exchange markets by Crnja (1993).

16. For details, see Kleidon (1995, sec. 2).

17. This is not restricted to the foreign exchange market. This phenomenon has been consistently described to us in conversations with both equity and foreign exchange traders.

61 Bid-Ask Spreads in Foreign Exchange Markets individual trader, the question is the interpretation of current trading behavior in the market. For example, is a request for a bid on a certain sized trade likely to be followed by the same trader for another? If so, then that will affect the terms offered for the first trade.

Significantly, traders report that, until they have got the feel of the market, they are uncertain of their "view" and hence, for example, of whether they will be going long or short one or another currency in their early trading during the day. This translates into initial high spreads, with rapidly changing quotes as traders develop their view for the current trading period.

This, of course, appears to correspond to the evidence that we presented in section 2.1 above at the open of trade. The market that has been trading for some time (London, at New York open) does not show any "excess volatility" relative to surrounding times, and the new traders (in New York) rapidly get the feel of the market, that is, assimilate important information about the current market structure that is not contained in the current price. While there is little documented evidence about the mechanisms that traders use to get the feel of the market, conversations with traders indicate that they include perusal of overnight information from various sources beyond the trading history of the particular currency being traded, as well as more formal arrangements with counterparts at overseas banks who agree to provide specific information about the market to the "novice" who is just starting to trade. One possibility consistent with our data (and not addressed by standard information models) is that the new dealers set wide spreads while they gather this information and then narrow the spreads once they are ready to trade.

However formal or informal the mechanism for obtaining information about the market structure, the level of spreads and the volatility of quotes settle down once traders get the feel of the market, and the markets trade in an integrated fashion until the next major disruption—the close of trading on one of the markets.

2.3.2 Inventory-Based Models: Close of Trade A large proportion of foreign exchange trading, including most of that done by smaller, regional banks, is "day trading," in which traders start and end the day with flat positions. While this does not cause any particular problems at the start of the day since positions can be accumulated during the trading day that has just begun, the inventory problem for day traders becomes increasingly acute as the close of trading approaches. In the limit, a trader who must close out a position by the end of the day has increasingly inelastic demand to trade and will be more willing to accept a relatively poor price to accomplish the trade.18

18. Brock and Kleidon (1992) exploit differences in trading demand at open and close to predict higher spreads at these times if a marketmaker such as a monopolist specialist has the ability to price discriminate at these times of inelastic demand to trade. This idea may have some application in foreign exchange markets, particularly with respect to quotes by regional banks to customers who have peak foreign exchange trading demands at open and close.

62 David A. Hsieh and Allan W. Kleidon The effects of inventory on prices and quotes are well discussed in market microstructure literature beginning with Garman (1976) (see also Amihud and Mendelson 1980; Ho and Stoll 1981, 1983; O'Hara and Oldfield 1986; and Son 1991). Recent empirical work in equity dealer markets in London (see Hansch, Naik, and Viswanathan 1993) and the United States (see Chan, Christie, and Schultz 1995) documents strong inventory effects, and Lyons (1995) documents inventory effects in the foreign exchange market. Discussions with traders in the foreign exchange market confirm that high quote volatility and spreads at close are linked by traders to the activities of day traders who are attempting to close out their positions.19

2.4 Conclusions In this paper, we have explored the implications of foreign exchange markets for alternate models of intraday price and volume behavior. There are empirical difficulties in reconciling current asymmetric information models with stock price data in individual markets, but it is possible for some form of these models to be consistent with NYSE prices and volume, assuming that liquidity traders have strong demand to trade at open and close for reasons that are not motivated within the information models. Our choice of the foreign exchange market is motivated by the ability to test whether any form of the current asymmetric information models can explain prices and volumes in this market.

The advantages of foreign exchange data are that the market extends around the clock and that traders from any location have equal access via computer terminal to the posted quotes of all traders from all locations. If new information is the cause for revisions in quotes for traders in, say, London, then those quote revisions are immediately indicated to all other traders. Moreover, since there is an overlap between the trading days of traders in London and New York, we can observe whether the quote behavior is integrated in the fashion implied by the asymmetrical information models.

The results are inconsistent with these models. If London and New York are examined individually, they display the same patterns of spread and volatility from "open" to "close" as does the NYSE, which may indicate similar forces in each market. However, when New York foreign exchange traders begin their day, with attendant high volatility and spreads, London has been trading for hours and is still trading. There is no effect on London quotes, in either volatility or spreads, of the striking New York quote behavior. Similarly, although London "closes" its day with high variances and high spreads, this does not cause a ripple on the quotes of New York traders. This is inconsistent with standard sources of asymmetric information being the fundamental cause of this behavior.

19. A related feature of the New York close is the decrease in depth of the market as traders stop trading, with a consequent increase in spreads.

63 Bid-Ask Spreads in Foreign Exchange Markets Our primary conclusion is that the current models of asymmetric information appear inadequate to explain our results. This raises questions concerning their application in other markets as well. Indeed, our findings are not limited to quotes in the foreign exchange market. Kleidon and Werner (in press) demonstrate that similar results apply to U.K. stocks that are cross-listed on London and New York exchanges and that consequently trade simultaneously in a similar fashion to the foreign exchange trading that we document here. It appears that we must turn to explanations other than current information models if we are to account for the behavior of prices and volumes in both stock and foreign exchange markets.

We suggest two possible explanations for the empirical results documented in section 2.1. First, we place importance at the open of trade on learning by traders about the structure of the market, particularly concerning the identity and behavior of other traders. This can be linked both to behavioral experimental results and to the results in recent literature that examines the implications for information aggregation of a lack of common knowledge among traders concerning the preferences and beliefs of market participants. During the period when traders pursue various mechanisms to learn the feel of the market, spreads may be set sufficiently wide to avoid trading at an informational disadvantage.

Second, at the close of trade, much of the activity in the closing market documented in section 2.1 may be due to the inventory-related activities of traders at market close, especially for the large group of day traders who must close their positions by the end of trading.

While these explanations seem plausible—and indeed are confirmed by foreign currency traders—further investigation is warranted.

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Admati, A. R., and P. Pfleiderer. 1988. A theory of intraday patterns: Volume and price variability. Review of Financial Studies 1:3-40.

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Brock, W. A., and A. W. Kleidon. 1992. Periodic market closure and trading volume: A model of intraday bids and asks. Journal of Economic Dynamics and Control 16:451-89.

64 David A. Hsieh and Allan W. Kleidon Burnham, J. B. 1989. Marketmakers, speculators and customers: The U.S. foreign exchange market. Working Paper no. 130. St. Louis: Center for the Study of American Business, Washington University.

Chan, K. C, W. G. Christie, and P. H. Schultz. 1995. Market structure and the intraday pattern of bid-ask spreads for Nasdaq securities. Journal of Business 68:35-60.

Crnja, Z. 1993. Environmental uncertainty in the foreign exchange market. Honors thesis, Department of Economics, Stanford University.

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Research Paper no. 88-108. Fuqua School of Business, Duke University.

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Comment Zhaohui Chen

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