Bid-ask spread dynamics in foreign exchange markets

- We examine the dynamic behaviour of dollar, sterling, and yen exchange rate spreads using a vector autoregressive process and show that spread shocks are caused by long run dependancies in the spread rather than by changes in inventory, adverse selection or order processing costs.
- Using the Iterated Cumulative Sum of Squares algorithim we also find that spread shifts are relatively uncommon.

The aim of this paper is to examine the short term dynamics of foreign exchange rate spreads. Using a vector autoregressive model (VAR) we show that most of the variation in the spread comes from the long run dependencies between past and future spreads rather than being caused by changes in inventory, adverse selection, cost of carry or order processing costs. We apply the Integrated Cumulative Sum of Squares (ICSS) algorithm of Inclan and Tiao (1994) to discover how often spread volatility changes. We find that spread volatility shifts are relatively uncommon and shifts in one currency spread tend not to spillover to other currency spreads.