Bid-ask bounce and speads in the foreign exchange futures market

  • Quentin C. Chu
  • David K. Ding
  • C. S. Pyun
Article

Abstract

This paper examines the intraday bid-ask bounce in Deutschemark and Japanese yen futures prices. The intraday Markovian bid-ask bounce process, which leads to a desirable equilibrium condition of reaching a bid or an ask transaction type with equal chances, is identified. A second-order Markov chain transition matrix model is used to derive a generalized estimator of bid-ask spreads in the foreign exchange futures market. It incorporates the conditional probabilities of a subsequent transaction being the same type as the current transaction's (δ) and that of the next transaction being the same as the current type but different from the previous type (α). The specification is {-Cov(ΔPtPt+1)/[(1−δ)(−α)]}1/2. The empirical results show that the average implied bid-ask spread is about $10, which is less than one tick's value of $12.50. It is also found that spreads are higher at the beginning and end of the trading day than the rest of the day, reflecting the uncertainty due to information flows and overnight inventory carrying costs, respectively.

Key words

bid-ask bounce bid-ask spread tick test Markovian analysis foreign currency futures 

Preview

Unable to display preview. Download preview PDF.

Unable to display preview. Download preview PDF.

References

  1. Benston, G.J. and R.L. Hagerman, “Determinants of Bid-Ask Spreads in the Over-the-Counter Market.” Journal of Financial Economics 1, 353–364, (December 1974).Google Scholar
  2. Bhattacharya, M., “Transactions Data Tests of Efficiency of the Chicago Board of Options Exchange.” Journal of Financial Economics 12, 161–186, (August 1983).Google Scholar
  3. Bickel, P. and K. Doksum, Mathematical Statistics. San Francisco: Holden-Day, 1977.Google Scholar
  4. Choi, J., D. Salandro, and K. Shastri, “On the Estiamtion of Bid-Ask Spreads: Theory and Evidence.” Journal of Financial and Quantitative Analysis 23, 219–230, (June 1988).Google Scholar
  5. Copeland, T. and D. Galai, “Information Effects on the Bid-Ask Spread.” Journal of Finance 38, 1457–1469, (December 1983).Google Scholar
  6. Garbade, K. and W. Silber, “Structural Organization of Secondary Markets: Clearing Frequency, Dealer Activity and Liquidity Risk.” Journal of Finance 34, 577–593, (July 1979).Google Scholar
  7. George, T., G. Kaul, and M. Nimalendran, “Estimation of the Bid-Ask Spread and Its Components: A New Approach.” Review of Financial Studies 4, 623–656, (1991).Google Scholar
  8. Glosten, L. and P. Milgrom, “Bid, Ask and Transaction Prices in a Specialist Market With Heterogeneously Informed Traders.” Journal of Financial Economics 14, 71–100, (March 1985).Google Scholar
  9. Harris, L., “Statistical Properties of the Roll Serial Covariance Bid/Ask Spread Estimator.” Journal of Finance 45, 579–590, (June 1990).Google Scholar
  10. Kuserk, G. and P. Locke, “Scalper Behavior in Futures Markets: An Empirical Examination.” Journal of Futures Markets 13, 409–431, (June 1993).Google Scholar
  11. Laux, P. and A.J. Senchack, “Bid-Ask Spread in Financial Futures.” Journal of Futures Markets 12, 621–634, (December 1992).Google Scholar
  12. Lee, C. and M. Ready, “Inferring Trade Direction From Intraday Data.” Journal of Finance 46, 733–746, (June 1991).Google Scholar
  13. Ma, C., R. Peterson, and S. Sears, “Trading Noise, Adverse Selection, and Intraday Bid-Ask Spreads in Futures Markets.” Journal of Futures Markets 12, 519–538, (October 1992).Google Scholar
  14. McInish, T. and R. Wood, “An Analysis of Intraday Patterns in Bid/Ask Spreads for NYSE Stocks.” Journal of Finance 47, 753–764, (June 1992).Google Scholar
  15. McQueen, G. and S. Thorley, “Are Stock Returns Predictable? A Test Using Markov Chains.” Journal of Finance 46, 239–263, (March 1991).Google Scholar
  16. Roll, R., “A Simple Implicit Measure of the Effective Bid-Ask Spread in an Efficient Market.” Journal of Finance 39, 1127–1139, (September 1984).Google Scholar
  17. Ross, S., Introduction to Probability Models, 4th edition. San Diego, CA: Academic Press, 1989.Google Scholar
  18. Silber, W., “Marketmaker Behavior in an Auction Market: An Analysis of Scalpers in Futures Markets.” Journal of Finance 39, 937–953, (September 1984).Google Scholar
  19. Stoll, H., “Inferring the Components of the Bid-Ask Spread: Theory and Empirical Tests.” Journal of Finance 44, 115–134, (March 1989).Google Scholar
  20. Thompson, S. and M. Waller, “Determinants of Liquidity Costs in Commodity Futures.” Review of Futures Markets 7, 110–126, (1988).Google Scholar

Copyright information

© Kluwer Academic Publishers 1996

Authors and Affiliations

  • Quentin C. Chu
    • 1
  • David K. Ding
    • 2
  • C. S. Pyun
    • 3
  1. 1.Department of Finance, Insurance and Real Estate, Fogelman College of Business and EconomicsThe University of MemphisMemphisUSA
  2. 2.Division of Banking and Finance, School of Accountancy and BusinessNanyang Technological UniversitySingaporeSingapore
  3. 3.Department of Finance, Insurance and Real Estate, Fogelman College of Business and EconomicsThe University of MemphisMemphisUSA

Personalised recommendations