The Microstructure of Currency Markets: an Empirical Model of Intra-day Return and Bid-Ask Spread Behavior

This paper analyzes the intra-day relationship between bid-ask spreads and “market ” return volatility for quotes posted in a truly global “around-the-clock ” market setting, the one for the U.S. Dollar/Deutschemark exchange rate. We are able to identify a statistically and economically significant “Reverse U-shaped ” pattern in the bid-offer spread in 1996. Tests of the stability and ordering of “market ” volatility, performed across several different fractions of the day, reveal that variances of intra-day returns are heterogeneous and ordered, declining around the Asian lunch break, increasing steadily during the London morning trading hours, peaking at the opening of New York to subsequently fall with the closing of the European markets. Results also indicate that “market ” volatility is significantly higher during intra-day versus overnight periods. Then, we introduce a structural model that attempts to explain those empirical regularities by capturing some currency-specific features of the data: possibly asymmetric and stochastic trading cost structure, discrete directional updates and parameters ’ temporal heterogeneity, and by relating the bid-ask spread to two different sources of variation: trading costs and market risk. We evaluate these components via GMM using a set of convenient unconditional intra-day moments implied by the basic configuration of the model. Analysis of the resulting estimated patterns reveals that trading costs play a significant role in explaining the intra-day variability of bi