Spread components and dealer profits in the interbank foreign exchange market. Working Paper S-98-4, Stern School of Business, N.Y.U. 31 Research Report Series All reports can be downloaded from our website www.sifr.org, under the heading Research. Report

This paper is a revised version of chapter two of my Ph.D. dissertation at New York University. I wish to thank members of my dissertation committee, Joel Hasbrouck (co-chair) and Richard Levich (co-chair) and Matthew Richardson for encouragement and suggestions. I am grateful to Heinz Riehl, David Buchen and a major commercial bank in New York City for providing the foreign exchange dealing data used in this study. All errors are entirely my own. This paper studies dealer trading profits, spread components and implications for market making costs for a representative dealer in the foreign exchange market. Though accounting for only about 14 % of total trade volume, customer trades generate about 75 % of the dealer’s gross trading profits. Inter-dealer trades have negligible profit implications for the dealer who maintains his function as a liquidity provider by taking inter-dealer trades and subsequently offsetting the trades at other dealers ’ quotes. The FX dealer engages in very limited speculation (less than 5 % of total volume) and seems to profit from his brief informational advantage upon observing order flows. This contradicts with the popular conjecture that attributes high inter-dealer volume and short term market volatility to FX dealers ’ excessive speculation. Dealer trading profits are analyzed from another perspective by decomposing the spread components as in Glosten and Harris (1988). This study extends the existing approach to account for lagged quote adjustments to order flows facilitated by the low market transparency of FX markets. The FX dealer is found to bear only about one-third of the adverse selection costs as a result of risk sharing among market participants arising from the existing FX market structure. Moreover, inventory control costs are estimated to account for at least 70 % of the profits that the dealer would have made in a naive model where a dealer collects half of the quoted spread on each trade. 11