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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 U.S. Dollar/Deutschemark quotes. 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 different sources of random noise. We evaluate these parameters 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 bid and offer currency returns. Inventory considerations appear to be more relevant in the trading morning, while the perceived risk of arrival of informed trades seems more likely to affect the dealers' cost structure in the afternoon. The contribution of the "true" currency risk to the total variability of posted bid and ask quotes' returns is not surprisingly highest with the opening of the European markets.