Just Another Day in the Inter-bank Foreign Exchange Market

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Abstract
In spite of a sizeable literature exploring the formation of bid-ask spreads in stock markets, similar examination of the foreign exchange market has been lacking. The decentralized nature of the direct inter-dealer foreign exchange market distinguishes itself from the NYSE-type specialist markets. In this paper I first develop a theory of bid-ask quotes provided by foreign exchange dealers based on their beliefs and their inventory positions. I then consider the direct inter-dealer foreign-exchange market as a complex system and build an agent-based model in which artificial dealers offer quotes according to this theory and update their beliefs on the basis of new information available in one another's quotes in a Bayesian manner. I find that the resulting spreads and between-quotes returns largely conform to the empirically observed intra-day U-shaped pattern - a feature that has not been satisfactorily explained in the literature. Further, I look into the factors that influence the levels of spreads, spread volatility and return volatility at the beginning and close of trading relative to the day's average levels. I find that the prices of overnight risk and intra-day risk and the degree of initial disagreement about the correct value affect the spread and spread volatility. Return volatility is affected by these as well as other factors. The manner in which these parameters affect the variables, however, is non-linear and complex.
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