Decomposing the Bid–ask Spread in Multi‐Dealer Markets

Abstract

In this paper, we modify the Huang and Stoll (1997) spread-decomposing model to fit multi-dealer markets. In a multi-dealer market, individual dealers can rebalance their inventories either by trading with other dealers or changing the quote price. Our modified model captures this feature. Using transaction data from the Reuters D2000-1 system, we find that the order-processing and inventory control components of the spread in the foreign exchange market are relatively small and dealers may tolerate the unwanted inventory to keep the spread small to attract informed orders. The asymmetric information component carries the biggest weight.We study the time pattern of the spread and its components. The spread varies significantly with the time of day, but the inventory control and asymmetric information components do not.