Bid/ask spreads in the foreign exchange market: An alternative interpretation

This paper examines the behavior of the bid/ask spread in the NZD/USD market. Consistent with recent research, I find that many dealers prefer to quote a single spread. Dealers quoting a time-varying spread do not appear to behave in a fashion consistent with microstructure theory. Further analysis shows that the spread's conformance with the predictions of microstructure theory arises from both intraregional and interregional variations in inventory holding costs. This helps explain the apparent paradox that bid/ask spreads in the foreign exchange market behave in accordance with microstructure theory despite the fact that many dealers prefer to quote a single spread.