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**Institutional Knowledge at Singapore Management University
**

Dissertations and Teses Collection (Open Access) Dissertations and Teses

2011

Analysis of Singapore's Foreign Exchange Market

Microstructure

Chee Wai Wan

Singapore Management University, cheewai.wan.2007@smu.edu.sg

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Recommended Citation

Wan, Chee Wai, "Analysis of Singapore's Foreign Exchange Market Microstructure" (2011). Dissertations and Teses Collection (Open

Access). Paper 75.

htp://ink.library.smu.edu.sg/etd_coll/75

ANALYSIS OF

SINGAPORE’S FOREIGN EXCHANGE

MARKET MICROSTRUCTURE

WAN CHEE WAI

SINGAPORE MANAGEMENT UNIVERSITY

2011

Copyright (2011) Wan Chee Wai

Analysis of

Singapore’s Foreign Exchange

Market Microstructure

by

Wan Chee Wai

Submitted to the School of Economics in partial fulfillment of the

requirements for the Degree of Master of Science in Economics

Thesis Committee:

Tse Yiu Kuen (Supervisor/Chair)

Professor of Economics

Singapore Management University

Hoon Hian Teck

Professor of Economics

Singapore Management University

Anthony Tay

Associate Professor of Economics

Singapore Management University

Singapore Management University

2011

Analysis of

Singapore’s Foreign Exchange

Market Microstructure

Wan Chee Wai

Abstract

This paper analyses the Singapore foreign exchange market from a

microstructure approach. Specifically, by applying and modifying the empirical

methodology designed by Bollerslev and Melvin (1994), we examine the

relationship between bid-ask spreads and the underlying volatility of the

USD/SGD. Our data set comprises high-frequency USD/SGD tick data of three

separate years (April-June 1989, April-May 2006, April-May 2009). We found

that for the USD/SGD: i) the size of bid-ask spreads are positively related to the

underlying exchange rate volatility; ii) the magnitude of the dependence on

underlying volatility increases as tick volume increases; and iii) the size of the

bid-ask spreads may also be positively related to the directional movement of

exchange rates.

i

Table of Contents

Table of Contents ......................................................................................................i

Acknowledgement ..................................................................................................iv

1 Introduction....................................................................................................... 1

1.1 The Singapore Foreign Exchange Market ........................................................................ 2

1.2 The Microstructure Approach to Exchange Rate Economics ........................................... 5

1.3 Organization of Thesis...................................................................................................... 9

2 Bid-Ask Spreads in Exchange Rates............................................................... 10

2.1 Bid-Ask Spreads and Asymmetric Information.............................................................. 11

2.2 Bid-Ask Spreads and Volatility....................................................................................... 18

2.3 Bollerslev & Melvin’s Model of Volatility and Bid-Ask Spread.................................... 21

3 Empirical Analysis.......................................................................................... 27

3.1 Empirical Methodology.................................................................................................. 28

3.2 Description of the Data................................................................................................... 34

3.3 GARCH Analysis ........................................................................................................... 44

3.4 Ordered Response Analysis ............................................................................................ 47

3.5 Incorporating Returns ..................................................................................................... 50

3.6 Summary......................................................................................................................... 53

4 Conclusion ...................................................................................................... 55

References.............................................................................................................. 57

Appendix 1 – EViews Results................................................................................ 60

A.1.1 Dataset 1: USD-DEM April 1989 to June 1989: ........................................................ 60

A.1.1.1 MA(1)-GARCH(1,1) Results: .................................................................................... 60

A.1.1.2 Ordered Probit Results: 4 Ordered Values.................................................................. 61

A.1.1.3 Ordered Probit (with Returns) Results: 4 Ordered Values.......................................... 62

A.1.1.4 Ordered Probit Results: 10 Ordered Values................................................................ 63

A.1.1.5 Ordered Probit (with Returns) Results: 10 Ordered Values........................................ 64

A.1.1.6 Ordered Logit Results: 4 Ordered Values................................................................... 65

A.1.1.7 Ordered Logit (with Returns) Results: 4 Ordered Values........................................... 66

A.1.1.8 Ordered Logit Results: 10 Ordered Values ................................................................. 67

A.1.1.9 Ordered Logit (with Returns) Results: 10 Ordered Values......................................... 68

A.1.2 Dataset 2: USD-USD April 1989 to June 1989: ......................................................... 69

A.1.2.1 MA(1)-GARCH(1,1) Results: .................................................................................... 69

A.1.2.2 Ordered Probit Results: 4 Ordered Values.................................................................. 70

A.1.2.3 Ordered Probit (with Returns) Results: 4 Ordered Values.......................................... 71

A.1.2.4 Ordered Probit Results: 10 Ordered Values................................................................ 72

A.1.2.5 Ordered Probit (with Returns) Results: 10 Ordered Values........................................ 73

A.1.2.6 Ordered Logit Results: 4 Ordered Values................................................................... 74

A.1.2.7 Ordered Logit (with Returns) Results: 4 Ordered Values........................................... 75

ii

A.1.2.8 Ordered Logit Results: 10 Ordered Values ................................................................. 76

A.1.2.9 Ordered Logit (with Returns) Results: 10 Ordered Values......................................... 77

A.1.3 Dataset 3: USD-USD April 2006 to May 2006: ......................................................... 78

A.1.3.1 MA(1)-GARCH(1,1) Results: .................................................................................... 78

A.1.3.2 Ordered Probit Results: 4 Ordered Values.................................................................. 79

A.1.3.3 Ordered Probit (with Returns) Results: 4 Ordered Values.......................................... 80

A.1.3.4 Ordered Probit Results: 10 Ordered Values................................................................ 81

A.1.3.5 Ordered Probit (with Returns) Results: 10 Ordered Values........................................ 82

A.1.3.6 Ordered Logit Results: 4 Ordered Values................................................................... 83

A.1.3.7 Ordered Logit (with Returns) Results: 4 Ordered Values........................................... 84

A.1.3.8 Ordered Logit Results: 10 Ordered Values ................................................................. 85

A.1.3.9 Ordered Logit (with Returns) Results: 10 Ordered Values......................................... 86

A.1.4 Dataset 4: USD-USD April 2009 to May 2009: ......................................................... 87

A.1.4.1 MA(1)-GARCH(1,1) Results: .................................................................................... 87

A.1.4.2 Ordered Probit Results: 4 Ordered Values.................................................................. 88

A.1.4.3 Ordered Probit (with Returns) Results: 4 Ordered Values.......................................... 89

A.1.4.4 Ordered Probit Results: 10 Ordered Values................................................................ 90

A.1.4.5 Ordered Probit (with Returns) Results: 10 Ordered Values........................................ 91

A.1.4.6 Ordered Logit Results: 4 Ordered Values................................................................... 92

A.1.4.7 Ordered Logit (with Returns) Results: 4 Ordered Values........................................... 93

A.1.4.8 Ordered Logit Results: 10 Ordered Values ................................................................. 94

A.1.4.9 Ordered Logit (with Returns) Results: 10 Ordered Values......................................... 95

iii

List of Figures & Tables

Figure 1: USD/SGD vs GDP & Quotes .....................................................................................3

Table 1: USD/SGD April-May 2006 Spread Behavior ..............................................................8

Table 2: Distribution of Spreads of USD/DEM April-June 1989.............................................32

Table 3: Quote Volume differences between B&M and Purchased Data USD/DEM 1989 .....35

Table 4: Frequency of No Spread Change reported by B&M USD/DEM 1989 ......................36

Table 5: Frequency of No Spread Change with Olsen USD/DEM 1989 .................................36

Table 6: Frequency Distribution of Spreads USD/DEM 1989.................................................37

Table 7: Volume of Quotes of USD/SGD April-June 1989......................................................37

Table 8: Frequency of No Spread Change for USD/SGD April-June 1989 .............................38

Table 9: Frequency Distribution of Spreads USD/SGD April-June 1989................................39

Table 10: Volume of Quotes of USD-SGD April-May 2006....................................................39

Table 11: Frequency of No Spread Change for USD-SGD April-May 2006 ...........................40

Table 12: Frequency Distribution of Spreads USD-SGD April-June 2006..............................41

Table 13: Volume of Quotes of USD/SGD April-May 2009....................................................41

Table 14: Frequency of No Spread Change for USD-SGD April-May 2009...........................42

Table 15: Frequency Distribution of Spreads USD-SGD April-May 2009..............................43

Table 16: GARCH Estimates for all Datasets ..........................................................................45

Table 17: Ordered Probit Estimates for all Datasets (4 ordered indicator values) ...................47

Table 18: Ordered Logit Estimates for all Datasets (4 ordered indicator values).....................47

Table 19: Ordered Probit Estimates for all Datasets (10 ordered indicator values) .................49

Table 20: Ordered Logit Estimates for all Datasets (10 ordered indicator values)...................50

Table 21: Ordered Probit Estimates (with Returns) for all Datasets (4 ordered values)...........51

Table 22: Ordered Logit Estimates (with Returns) for all Datasets (4 ordered values)............51

Table 23: Ordered Probit Estimates (with Returns) for all Datasets (10 ordered values).........52

Table 24: Ordered Logit Estimates (with Returns) for all Datasets (10 ordered values)..........52

iv

Acknowledgement

I would like to thank Professor Tse Yiu Kuen, Professor Hoon Hian Teck and

Professor Anthony Tay for their patience, guidance and advice to me with

regards to the completion of this thesis. Due to challenges in my professional

life (overseas posting!) and priorities in my personal life (wedding!), my

academic life (the completion of this thesis!) had unfortunately taken a backseat.

Without the generous assistance of these kind professors, this paper would never

have seen the light of day.

I also like to thank Ms. Lilian Seah for her tireless efforts with regards to the

administrative aspects of the thesis, and for tolerating my nonsense.

Lastly, I would like to thank Erfei for her love, patience, and steadfast

encouragement to me during this time when I spent more time on this thesis than

with her. I promise this will be my last part-time academic pursuit.

1

1 Introduction

In “Bid-Ask Spreads and Volatility in the Foreign Exchange Market – An

Empirical Analysis”, an early microstructure paper in 1994, Tim Bollerslev, and

Michael Melvin (henceforth, B&M), performed an empirical analysis on the

USD/DEM, one of the most highly-traded currency pair in 1989, and showed

that the size of the bid-ask spread of is positively related to its underlying

exchange rate uncertainty. Their dataset consist of more than 300,000

continuously recorded USD/DEM quotes over a 3 month period from April to

June in 1989.

In this paper, we want to examine whether B&M’s result is applicable to a much

lesser-traded currency belonging to a much smaller developing economy with a

government-managed floating exchange rate regime – the USD/SGD. We begin

with a dataset of the USD/SGD in the same 3 month period as per B&M. The

volume of USD/SGD quotes from April to June in 1989 is slightly over 8,000.

We also want to examine how relationship between the size of the bid-ask

spreads and exchange rate volatility changes as the USD/SGD grows in volume

and significance, and as Singapore evolves into a developed country. Hence, we

fast-forward 17 and 20 years into the future from 1989, and repeat the analysis

on over 600,000 USD/SGD quotes from April to May 2006, and on over 1

million USD/SGD quotes from the same months in 2009.

2

This paper examines the Singapore foreign exchange market from a

microstructure approach, specifically focusing on the bid-ask spreads of the

USD/SGD. We also present a review of some microstructure literature in this

area. But first, we provide more background to these two underlying themes in

the next two sections:

1.1 The Singapore Foreign Exchange Market

The Monetary Authority of Singapore operates a float regime for the Singapore

dollar that is managed against a basket of currencies of the country’s major

trading partners and competitors. The various currencies are given different

weights depending on the extent of trade dependence with that particular country.

The composition of the basket is revised periodically to take into account

changes in Singapore’ trade patterns.

The trade-weighted exchange rate is allowed to fluctuate within an undisclosed

policy band, which provides flexibility for the system to accommodate

short-term fluctuations in the foreign exchange markets as well as some buffer

in the estimation of Singapore’s equilibrium exchange rate.

On a trade-weighted basis, the SGD has appreciated against the exchange rates

of its major trading partners and competitors since 1981, reflected rapid

economic development, high productivity growth, and high savings rate.

3

The following figure shows the USD/SGD, Singapore GDP, and volume of

quotes over the months of April and May from 1989 to 2009.

USD/SGD vs GDP & Quotes

1.20

1.30

1.40

1.50

1.60

1.70

1.80

1.90

2.00

1988 1993 1998 2003 2008

Year

U

S

D

/

S

G

D

0

200

400

600

800

1000

1200

1400

1600

1800

G

D

P

S

$

B

/

Q

u

o

t

e

s

(

'

0

0

0

s

)

USD/SGD GDP Quotes

Figure 1: USD/SGD vs GDP & Quotes

1

From 1989 to 2009, as the Singapore GDP experienced a gradual growth from

SGD 61 billion in 1989 to SGD 266 billion in 2009, the USD/SGD fluctuated

between 1.40 and 1.90. Interestingly though, from 2002 onwards the growth of

USD/SGD quote volume for April and May experienced a sharp increase from

only 33,000 quotes in 2001 to 180,000 quotes in 2002. This growth would then

accelerate to 1,630,000 quotes in 2009. It is as if all of a sudden the Singapore

dollar started to become more widely traded than ever before. With increasing

volume, the underlying exchange rate volatility would also be expected to

increase. How much effect would this have on the bid-ask spreads of the

USD/SGD. We examine this using data from 1989, 2006, and 2009.

1

USD/SGD and GDP figures obtained from Singapore Department of Statistics (singstat.gov.sg); Quotes

volume obtained from Olsen Financial Technologies GmbH.

4

In 2006 the global economy had recorded a fourth consecutive year of strong

growth despite the drag from crude oil prices, a buildup in global electronics

inventories and adjustment in the US housing market. The MAS Annual Report

for 2005/2006 reported that “despite higher oil prices, rising interest rates and

natural disasters, the global economy expanded at a robust pace in 2005. This

growth momentum continued unabated in the first quarter of 2006. The strength

of the US economy was a major factor underpinning the continued growth of the

world economy last year. The US economy displayed remarkable resilience

against the backdrop of hurricane Katrina and 11 successive increases in the Fed

funds rate from 2.25% at the beginning of 2005 to 5% in May 2006. In the first

quarter of 2006, growth picked up strongly, led by a rebound in consumer

spending and business investment spending on equipment and software.”

The Singapore economy was also in a state of stability, as reported by the MAS

Annual Report 2005/2006: “In the early months of 2006, some signs of easing in

the domestic economy emerged with growth momentum slowing to 6.8% in Q1.

However, this is not indicative of a broad-based slowdown, but rather a

retraction to a more sustainable pace of growth.”

In 2009 the world found itself in the midst of the worst global financial crisis

ever since the Great Depression. The MAS Annual Report 2008/2009 reported

that “2008 was a tumultuous year for the global economy. While the surge in

5

commodity prices led to strong inflationary pressures in the first half of the year,

the onset of the global financial crisis caused world growth to fall sharply in the

later part of 2008 and into early 2009. The emergence of the Influenza A (H1N1)

virus in recent months has added a new dimension of risk to the fragile global

economy.”

The global financial crisis, which saw the collapse of Lehman Brothers in

September 2008, caused massive economic fallout worldwide. Amidst an

erosion of confidence, global trade and industrial production collapsed in the

first half of 2009, resulting in a 2.4% year-on-year contraction in world GDP

over the same period. During this time, the quote volume for USD/SGD (over

April and May) grew to over 1.6 million quotes, suggesting the increase in

volatility in the exchange rate.

1.2 The Microstructure Approach to Exchange Rate Economics

Exchange rate economics, the branch of international economics and finance

which attempt to explain the foreign exchange market, is an intriguing area of

research.

There are many theories of exchange rate determination, from the open economy

IS-LM models that are mandatory fare for any undergraduate economics course,

to more advanced models such as the Mundell-Fleming model, the

6

sticky/flexible-price monetary models, and the portfolio balance model. More

recently, new open-economy macroeconomists attempt for formalize exchange

rate in the context of dynamic general equilibrium models with explicit

microfoundations, nominal rigidities and imperfect competition.

When tested against empirical evidence, these theories have various degrees of

success in forecasting long-run exchange rates. All of them however are not able

to convincingly explain short-run exchange rate fluctuations.

From a common-sense perspective, this is hardly surprising. If the long-run

exchange rate between two countries is expected to change due to some shifting

fundamental value (say productivity level, for example), how would any macro

model (even one with microfoundations) designed to determine the “new”

equilibrium exchange rate be able to take into account all the possible paths

taken to transit from the “old” equilibrium rate to the “new” one? Some foreign

exchange transactions between the two countries might be related to shifting

fundamentals (e.g. import/export transactions), but others transactions may not

(e.g. tourism, speculation in each others’ asset markets, etc).

Macro foreign exchange models often assume that foreign exchange rates will

move when fundamentals move. But foreign exchange rates can only move

through a trading process in a foreign exchange market. Foreign exchange

7

microstructurists study this trading process.

In his book, “The Microstructure Approach to Exchange Rates”, Richard Lyons

(2001) defined “Order Flow” and “Bid-Ask Spreads”, two variables that are

absent from the macro approach, as the two hallmarks of the microstructure

approach. These are analogous to “Quantity” and “Price” in the dimension of

exchange rates.

Order flow is essentially transaction volume which is “signed”, meaning it

includes information if the transaction is a sale or a purchase. Such data is

usually hard to come by and are proprietary to banks and other high-level

participants in the foreign exchange market.

Well-connected researchers, such as Martin D. D. Evans and Richard K. Lyons

managed to obtain proprietary data on all end-user EUR/USD trades received at

Citibank over 6.5 years. In their 2007 paper “Exchange Rate Fundamentals and

Order Flow", they tested and established four empirical results: (1) transaction

flows forecast future macro variables such as output growth, money growth, and

inflation, (2) transaction flows forecast these macro variables significantly better

than the exchange rate does, (3) transaction flows (proprietary) forecast future

exchange rates, and (4) the forecasted part of fundamentals is better at

explaining exchange rates than standard measured fundamentals.

8

Data for the other hallmark, Bid-Ask Spreads, on the other hand, is much easier

to obtain. In fact, the four datasets for this paper were purchased from Olsen

Financial Technologies GmbH, while B&M obtained theirs by collecting every

USD/DEM quote posted on the Reuters screen for the interbank foreign

exchange market for three months in 1989. But other than being easily

obtainable, Lyons highlighted that one reason spreads receive so much attention

is because, being a core element of most data sets, they are a ready target for

testable hypotheses. This is in contrast to other features in the trading that are

not so easily measurable, such as information flow, belief dispersion, etc.

The behavior of bid-ask spreads in the foreign exchange markets offers many

opportunities for research. For example, Table 1 below shows the distribution of

over 600,000 USD/SGD quotes in April and May 2006, divided into nine

categories of price and spread movements.

SPREAD SPREAD SPREAD

UP SAME DOWN

PRICE UP 32.46% 6.35% 3.53%

PRICE SAME 4.05% 7.52% 3.42%

PRICE DOWN 3.21% 6.60% 32.85%

Total 39.73% 20.47% 39.81%

Table 1: USD/SGD April-May 2006 Spread Behavior

Out of over 600,000 quotes over two months, the spread remained unchanged

6.35% of the time when the price moved up, and 6.60% of time when the price

moved down. Though we may somewhat expect for spreads to move when

prices move, what is intriguing is that when prices move up, spreads tended to

9

widen 32.46% of the time, but yet narrowed only 3.53% of the time, Conversely,

when prices move down, spreads tended to narrow 32.85% of the time but yet

widened only 3.21% of the time.

Spread behavior like in the previous example may differ across different

currencies within the same time period, and may also differ across different time

periods within the same currency. The empirical objective of this paper is thus to

examine the relationship between the bid-ask spread and the underlying

exchange rate volatility from such two angles. The main currency for analysis is

the USD/SGD. For comparison against a different currency within the same time

period, we use B&M’s results for the USD/DEM. For comparison against

different time periods within the same currency, we perform this analysis for the

USD/SGD from the months of April and May in 1989, 2006, and 2009. In

addition, we also perform an empirical analysis on the phenomenon described

above in Table 1.

1.3 Organization of Thesis

The rest of this paper shall be organized as follows: Chapter 2 begins with a

review of microstructure papers which concerns bid-ask spreads, and ends with

a description of B&M’s model that relates volatility to bid-ask spreads. Chapter

3 describes B&M’s empirical methodology and presents the empirical analyses

for each dataset. Chapter 4 concludes.

10

2 Bid-Ask Spreads in Exchange Rates

As previously mentioned in Chapter 1, Lyons (2001) cites bid-ask spreads as

one of the two hallmarks of the microstructure approach. Besides being

relatively obtainable, he explained that spreads receive so much attention

because they form a core element of most data sets and are a ready target for

testable hypotheses. He also gave two more reasons for the heavy attention and

resources focused on bid-ask spreads.

The second reason was because practitioners are “intensely concerned with

managing trading costs”. The third reason had to do with the history of the field

of market microstructure which in its early days sought to distinguish itself from

the literature on trading under rational expectations. Rational expectations

models generally omit trading mechanisms when characterizing the relationship

between fundamentals and price. Contrastingly market microstructure focused

on how trading mechanisms affected prices, and this had led to “a focus on the

determination of real-world transaction prices – spreads.”

For the first section of this Chapter, guided by Sarno & Taylor (2002), we

present a short survey on some early microstructure literature that concerns the

determination of bid-ask spreads, and focus on “adverse selection” as a popular

theme. We then present the views of a more contemporary paper which refutes

11

“adverse selection” as a determinant of bid-ask spreads and proposes that

asymmetric information might be a more plausible candidate.

From the second section of this Chapter we return to our main topic of interest –

bid-ask spreads and exchange rate volatility. Similarly, following Sarno &

Taylor (2002), we first present a short survey on the literature which analyses

the proportional relationship between spreads and exchange rate volatility.

We then close this Chapter by presenting B&M’s simple asymmetric

information model which forms the framework for our empirical investigation.

2.1 Bid-Ask Spreads and Asymmetric Information

Sarno & Taylor (2002) identifies three main determinants of the bid-ask spread:

the cost of dealer services, inventory holding costs, and the cost of adverse

selection.

Cost of Dealer Services

The cost of dealer services is formally analyzed by Demsetz (1968) who

assumes the existence of some fixed costs of providing “predictable immediacy”

as the service for which compensation is required by market makers. While

Demsetz focused on the New York Stock Exchange, his definition for cost of

dealer services could also be applicable to the foreign exchange market.

12

According to Demsetz, “predictable immediacy is a rarity in human actions, and

to approximate it requires that costs be borne by persons who specialize in

standing ready and waiting to trade with the incoming orders of those who

demand immediate servicing of their orders. The ask-bid spread is the markup

that is paid for predictable immediacy of exchange in organized markets; in

other markets, it is the inventory markup of retailer or wholesaler”.

Inventory Holding Costs

The original argument of inventory costs as a crucial determinant of bid-ask

spreads was first propositioned by Barnear & Logue (1975), who tested a

modified theory of market-maker behavior first espoused by Bagehot (1971).

Barnear & Logue modified the theory of the market-maker spread by

distinguishing between the two major components of inventory risk. The second

component, which they termed “marketability risk”, relates to the market

maker's ability to make inventory adjustments when the market for an issue is

"thin." They showed that volume has a negative effect on the bid-ask spread for

two reasons: 1) high volume implies more competition if it implies more

competition among alternative market makers; and 2) high volume implies less

marketability risk, and, therefore, lower positioning costs.

Amihud & Mendelson (1980) considers the problem of a price-setting

monopolistic market-maker in a Garman (1976) dealership market where the

13

stochastic demand and supply are depicted by independent Poisson processes.

The focus of their analysis is the dependence of the bid-ask prices on the

market-maker’s inventory position. They derived the optimal policy the results

are shown to be consistent with some conjectures and observed phenomena, like

the existence of a ‘preferred’ inventory position and the downward monotonicity

of the bid-ask prices.

Ho & Stoll (1981) considers the stochastic dynamic programming problem of

solving for the optimal behavior of a single dealer of a single stock who is faced

with a stochastic demand for his services and return risk on his stock and on the

rest of his portfolio. They show that as time unfolds and transactions occur, the

dealer is able to set his bid price and ask price relative to his opinion of the

"true" price of the stock so as to maximize the expected utility of terminal

wealth. The bid-ask spread is given by a risk neutral spread that maximizes

expected profits for the given stochastic demand functions plus a risk premium

that depends on transaction size, the return variance of the stock and the dealer's

attitude toward risk. The bid-ask spread does not depend on the dealer's

inventory position, but the dealer’s price adjustment does. When inventory

increases both bid price and ask price decline, and the converse is true when

inventory decreases.

14

Generally, inventory costs models assume that market-markers optimize their

inventory holding, and generally imply that market-makers shift the spread

downwards and increase the width of the spread when a positive inventory is

accumulated.

Cost of Adverse Selection

Adverse selection is a common argument to explain the existence of bid-ask

spreads. The origin of this argument could be traced back to Bagehot (1971),

whose model includes two types of market participants – those are willing to

pay the price of the spread to the market-maker in exchange for predictable

immediacy and those who can speculate at the expense of the market-maker

using some private insider information. An adverse selection arises because

market-makers are not able to distinguish between the two types of participants

and resort to widening the spreads for both types. The bid-ask spread then

becomes the market-maker’s defense against adverse selection in “in the form of

exploitation of arbitrage opportunities”. Since Bagehot, numerous

microstructure papers have drawn on adverse selection as their primary

interpretive framework.

Copeland & Galai (1983) analyses the determination of bid-ask spreads in

organized financial markets, where the trading is done through economic agents

who specialize in market-making for a limited set of securities. The commitment

15

made by dealers to buy or sell at the bid and ask prices, respectively, is analyzed

as a combination of put and call options. Given the behavior of liquidity traders

and informed traders, the dealer is assumed to offer an out-of-the-money

straddle option for a fixed number of shares during a fixed time interval. The

exercise prices of the straddle determine the bid-ask spread. The dealer

establishes his profit maximizing spread by balancing the expected total

revenues from liquidity trading against the expected total losses from informed

trading. They showed that a monopolistic dealer will establish a wider bid-ask

spread than will perfectly competitive dealers, and that the bid-ask spread

increases with greater price volatility in the asset being traded, with a higher

asset price level, and with lower volume.

Glosten & Milgrom (1985) analyzed a model of a securities market in which the

arrival of traders over time is accommodated by a market-maker. They showed

that adverse selection, by itself, could account for the existence of a bid-ask

spread, and the average magnitude of the spread depends on many parameters,

including the exogenous arrival patterns of insiders and liquidity traders, the

elasticity of supply and demand among liquidity traders, and the quality of the

information held by insiders. They also showed that, because transaction prices

are informative, bid-ask spreads tend to decline with trade.

16

Lyons (1995) was likely one of the first who departed from early microstructure

work that focused almost entirely on stock markets and applied such theory to

foreign exchange markets. He presented a model which incorporated a number

of institutional features relevant to the FX market, such as the facts that major

currencies are traded in decentralized dealership markets; that over 80% of the

trading volume is between market-makers; that market net volume is only

partially observable; and that customer order flow is an important source of

private information. Lyons showed that trade size and the bid-ask spreads of a

particular dealer were positively related.

Payne (2003) estimates a VAR decomposition of interdealer trades and quotes

and interprets the results through the lens of adverse selection. Specifically, he

used one trading week’s worth of USD/DEM data derived from an electronic

foreign exchange brokerage and employed the framework contained in

Hasbrouck & Sofianos (1993) to test for the existence of private information

effects of trading on prices. His basic results confirm the existence of private

information on FX markets, indicating that adverse selection costs account for

around 60% of the half-spread.

Osler, Mende & Menkhoff (2006) however shows evidence that the behavior of

bid-ask spreads is inconsistent with adverse selection. They outline three factors

that seem likely to be important. The first factor, fixed operating costs, can

17

explain the negative relation between trade size and bid-ask spreads if some

costs are fixed, but cannot explain the cross-sectional variation across customer

types. To explain why bid-ask spreads are larger for commercial than financial

customers they suggest that asymmetric information – in the broad sense of

information that is held by some but not all market participants – may influence

spreads through two channels distinct from adverse selection, one involving

market power and a second involving strategic dealing.

The market power hypothesis suggests that firms, even in a market with

hundreds of competitors like foreign exchange, gain market power from holding

information. It can be costly for customer firms to search out the best available

quotes in the foreign exchange market, so each individual dealer can exert a

certain amount of market power despite the competition. As suggested in Green

et al. (2005), dealers may quote the widest spreads when their market power is

greatest, and market power in quote-driven markets depends on knowledge of

current market conditions. In foreign exchange, commercial customers typically

know far less about market conditions than financial customers so they might be

expected to pay wider spreads, as they do.

The second channel through which asymmetric information might affect bid-ask

spreads in foreign exchange involves strategic dealing. Building on abundant

evidence that customer order flow carries information (e.g., Evans and Lyons

18

(2007), Daníelsson et al. (2002)), Osler et al argue that rational foreign exchange

dealers might strategically vary spreads across customers, subsidizing spreads to

informed customers in order to gain information which they can then exploit in

upcoming interbank trades. In standard adverse-selection models, by contrast,

dealers passively accept the information content of order flow. The idea that

dealers strategically vary spreads to gather information was originally explored

in Leach and Madhavan (1992, 1993). When applied to two-tier markets in Naik

et al. (1999) it implies that bid-ask spreads will be narrower for trades with

information, consistent with the pattern in foreign exchange.

2.2 Bid-Ask Spreads and Volatility

The directly proportional relationship between bid-ask spreads and exchange

rate volatility now represents a fairly stylized fact in the microstructure literature.

Early studies modeled the spread as a function of transaction costs, the bank’s

profit from providing liquidity services, and the market-maker’s payoff for

facing the exchange rate risk when assuming an open position. The main

conclusions of these early studies are that exchange rate spreads are wider under

floating exchange rate than under fixed-exchange rate regimes (e.g. Aliber,

1975), and that measures of exchange rate volatility are followed closely by

exchange rate spreads (e.g. Fieleke, 1975; Overturf, 1982).

19

Glassman (1987) provides a significant contribution to this literature in that she

builds a model where variables representing transactions frequency are included

explicitly and the non-normality of the distribution of exchange rates is taken

into account. The model not only provides additional evidence on the

proportional relationship between exchange rate volatility and bid-ask spreads in

the foreign exchange market, but also suggests that market-makers consider

moments of the exchange rate higher than the second moment in order to

evaluate the probability of large exchange rate changes.

Admanti & Pfleiderer (1988) provides another fundamental theoretical

contribution to this area. In their model, there are three types of agents: informed

traders, who have relatively superior information and only trade on terms

favorable to them; discretionary liquidity traders, who must trade during a day

but can choose when to trade during the day in order to minimize costs; and

non-discretionary liquidity traders, who must trade at a precise time during the

day regardless of the cost. In this model, trading volume is explained by the

concentration of trade of informed traders and discretionary liquidity traders at

certain points in time: the concentrations occur because it is profitable for

informed traders to trade when there are many liquidity traders who do not have

the same information as themselves and because discretionary liquidity traders

are attracted because the larger the number of traders lowers the cost of trading.

20

Bollerslev & Domowitz (1993) used intradaily data to investigate the behavior

of quote arrivals and bid-ask spreads. They recorded quote arrivals and bid-ask

spreads over the trading day, across geographical locations as well as across

market participants. They found that trading activity and the bid-ask spreads for

traders whose activity is restricted to regional markets can be described by a

U-shaped distribution, which is consistent with Admanti & Pfleiderer’s (1989)

model. The patterns of trading activity and spreads during the day also strongly

suggest some degree of traders’ risk aversion, given which, the more trading

activity is executed by informed traders, the higher the cost of trading.

Goodhart & Figliuoli (1991) reported a study of minute bid-ask quotes on three

days in 1987 at a Reuters screen and found evidence that leptokurtosis and

heteroscedasticity are time-varying, and are less pronounced at the

minute-by-minute frequency than at lower frequencies. They also found that

trading volume is time-varying, being higher at the European and North

American openings and lower at the European lunch hour. The series was also

found to exhibit first-order negative serial correlation, which is especially

pronounced after immediately after jumps in the exchange rate. Multivariate

analysis suggested significant relationships between lagged exchange rates and

the current spot rate.

21

2.3 Bollerslev & Melvin’s Model of Volatility and Bid-Ask Spread

B&M is the main inspiration for this thesis, providing most importantly a

methodology to analyze the relationship between bid-ask spreads of exchange

rates and its underlying volatility.

In the early 1990’s as B&M were writing their paper, the bid-ask spread

component of transactions costs in the foreign exchange market had not received

much attention in the literature. Earlier studies on the subject, such as Glassman

(1987) and Boothe (1988), concentrated on the own statistical properties of the

spread. Researchers, such as Goodhart (1990), Bossaerts and Hillion (1991),

Black (1991), Melvin and Tan (1996) and Bollerslev and Domowitz (1993), had

attempted to offer empirical and theoretical analyses of the determinants of

foreign exchange market spreads, but no one had performed any explicit

analysis of the relationship between the magnitude of foreign exchange market

spreads and the underlying exchange rate volatility. Hence, B&M is likely to be

the first paper to touch on this subject.

B&M opined that while unambiguous 'good' or 'bad' news regarding the

fundamentals of the exchange rate should have no systematic effect on the

spread, as both the bid and the ask prices should adjust in the same direction in

response to the traders receiving buy or sell orders that reflect the particular

news event, however greater uncertainty regarding the future spot rate, as

22

associated with greater volatility of the spot rate, is likely to result in a widening

of the spread.

We now outline B&M’s simple theoretical framework that illustrates this role of

volatility in determining the spread.

The formal setup for B&M’s stylized market microstructure model is based on

the analysis in Glosten and Milgrom (1985), Admati and Pfleiderer (1989), and

Andersen (1993).

The model assumes that the foreign exchange market comprises two kinds of

traders: liquidity traders and information-based traders. Liquidity traders

participate in foreign exchange transactions only due to the needs of their

normal business activity which require international trade of goods, services and

financial assets. They are also not speculators. Information-based traders profit

by intermediating the demands and supplies of foreign exchange for the liquidity

traders. These traders also take positions in the foreign exchange market based

on information advantages received through their dealings with the liquidity

traders or, more generally, information asymmetries regarding fundamentals

underlying the determination of the spot exchange rate.

23

The liquidity traders constitute the proportion (1—ì) of the total market

participants. The liquidity traders receive a signal to either buy or sell foreign

currency regardless of the actual value of the currency in comparison with the

bid or ask prices prevailing at the time. Informed traders constitute the

remaining ì proportion of the market. This group of traders receives some

information about the true underlying fundamental value of the exchange rate s

t

.

This fundamental value is assumed to evolve over time according to a

martingale model,

(1)

where E

t-1

(c

t

)=0, E

t-1

(c

t

2

)= o

t

2

, and E

t-1

(•)

denotes the conditional expectation

based on the information set generated by the past values of s

t

. B&M further

assumes that the standardized innovations, c

t

o

t

-1

, are independent and

symmetrically, but not necessarily identically, distributed through time.

At time t-1, one of the many market-making traders will set bid and ask quotes,

B

t

and A

t

, good for trading at time t. The bid-ask spread is assumed to be set

symmetrically around the known fundamental price prevailing at the time of

quote formation, i.e. A

t

= s

t-1

+ k

t,t-1

, and B

t

= s

t-1

– k

t,t-1

. Thus, the quoted spread

for trades at time t, K

t

= A

t

, - B

t

= 2k

t,t-1

depends on time t-1 information only.

24

Trades at existing quotes will generate losses, on average, for the market-maker

when the opposite party an information-based trader. Information-based traders,

who received the signal c

t

buy currency if A

t

< s

t

and sell currency if s

t

, < B

t

. For

values of B

t

≤ s

t

≤ A

t

, the information-based traders cannot profit from

knowing the true fundamental value revealed by c

t.

The liquidity traders only

know s

t-1

and expect c

t

to equal zero.

Trader positions are limited by the convention that existing quotes are only good

for up to some maximum quantity of currency. Assuming that the market-makers

limit trading to one unit of currency at existing quotes, the loss for the quoting

trader relative to the true value s

t

arising from informed trading is therefore

(2)

Let P

t-1

(•) denote the probability conditional on the time t-1 information. Since

the standardized innovations, Z

t

= c

t

o

t

-1

, are assumed to be independent and

symmetrically distributed through time, the expected loss from informed trading

may be expressed as

(3)

25

Assuming an equal probability of a buy or a sell order from the liquidity traders,

it follows that the expected profit for the quoting trader conditional on an

uninformed trade equals:

(4)

Combining the expected trading loss in Eq. (3) with the gain in Eq. (4) yields the

expected profit for the market-maker conditional on time t-1 information:

In equilibrium, competition from other banks or market-makers will drive this

expected profit to zero. Expressing this zero profit condition in terms of the total

spread, K

t

=2

kt,t-1

yields

(6)

Since the conditional expectation and probabilities on the right-hand side of Eq.

(6) only depend on the time t-1 information set through o

t-1

k

t,t-1

, it follows that in

26

equilibrium the spread must move proportional to the conditional standard

deviation of the true fundamental value of the exchange rate.

B&M noted that while this simple proportionality condition would no longer

hold true in a more general model with endogenous information acquisition, the

result that an increase in o

t

2

leads to an increase in K

t

would still remain

generally valid.

Based on this relationship between exchange rate volatility and the bid-ask

spread, B&M designed the empirical methodology that we will describe in the

next chapter.

27

3 Empirical Analysis

B&M performed an empirical analysis on the USD/DEM, one of the most

highly-traded currency pair between two of the largest economies in the world in

1989 and showed that the size of the bid-ask spread of the USD/DEM is

positively related to its underlying exchange rate uncertainty. The USD/DEM is

a free-floating exchange rate. Their dataset consist of more than 300,000

continuously recorded USD/DEM quotes over a 3 month period from April to

June in 1989.

We are curious if 1) B&M’s result would hold for the USD/SGD, a semi-floating

currency from a much smaller economy, where over the same period from April

to May 1989, there were only slightly over 8,000 quotes; 2) B&M’s result would

hold 17 years later for that same currency, as that country becomes a significant

regional economic power in South-east Asia, and when the volume of quotes

increased to over 600,000 over April and May 2006.; and 3) B&M’s result

would hold as that economy enters into a period of worldwide financial crisis.

For the above purposes we purchased four sets of data from Olsen Financial

Technologies GmbH. Before we discuss the data and empirical results, we first

describe B&M’s empirical methodology and how we adapted it for this paper.

28

3.1 Empirical Methodology

B&M’s empirical methodology comprises two major steps.

Step 1: Creating a Proxy for Exchange Rate Volatility

The first step involves using a GARCH model as an explicit proxy for the

time-varying volatility of the spot rate, and as noted by Bollerslev et al. (1992),

such representations have been documented by numerous studies. B&M

employed a two-stage estimation procedure in which the conditional variance

for the spot exchange rate is first estimated as a GARCH process. These

estimates for the conditional variance are then used as the proxy for exchange

rate volatility in the second-stage model for the temporal behavior of the spread.

B&M use the ask price for estimation purposes; the bid and ask prices have

virtually identical higher order moments and differ only very slightly in their

conditional means. They found that the MA(1)-GARCH(1,1) model of the form

below seemed to fit their dataset well:

(7)

where I

t-1

denotes the time t-1 information set, and µ, u, e, o, and | are the

parameters to be estimated. The time t subscript refers to the place in the order

29

of the series of quotes, so that o

A,t

2

provides an estimate of the price volatility

between quotes.

The particular specification for the conditional variance in Eq. (7) may be

justified by the theoretical arguments in Nelson (1990, 1992). Intuitively, if the

sample path for the true unobservable volatility process is continuous, it follows

that on interpreting the GARCH(1,1) model as a non-parametric estimator, or a

one-sided filter, the resulting estimates for the conditional variance will

generally be consistent as the length of the sampling interval goes to zero.

The primary purpose of the GARCH estimation was to create proxies for the

conditional variance of the exchange rate to be used in the investigation of the

determinants of the spread.

But it was 1993 then, and B&M noted that estimating a GARCH model with

more than 300,000 observations in practice was not feasible in practice. Hence,

they divided up their dataset into 12 weeks of data and estimated each set for the

above GARCH parameters. They then saved all the estimates for the conditional

variances from each of the 12 models and combined into a single time series of

volatility estimates for the full set of weekday quotes. Today, we use modern

econometrics software EViews to perform GARCH analysis on our datasets and

to obtain the conditional variance time series.

30

Step 2: Estimate Relationship between Spreads and Proxy for Volatility

The second major step of the methodology involved using ordered response

models to estimate the relationship between the time series of volatility

estimates obtained in the first step and the bid-ask spreads.

Specifically, B&M used an Ordered Probit model with multiplicative

heteroskedasticity for this purpose.

The observed spread, K

t

, is assumed to take on only a fixed number of discrete

values, a

1

, a

2

, … a

J

. The unobservable continuous random variable, K*, is

defined by

K

*

t

= X

i

’| + c

K,t

(8)

The vector X

t

denotes a set of predetermined variables that affect the conditional

mean of K*

t

and c

K,t

, is conditionally normally distributed with mean zero and

variance, c

2

K,t

(9)

B&M allowed for multiplicative heteroskedasticity in the spread by

parameterizing the logarithm of o

2

K,t

as a linear function of the same

31

explanatory variables that enter the conditional mean of K*

t

.

We depart from this path in our analysis, firstly by omitting multiplicative

heteroskedasticity (more due to the limitations of EViews than by choice), and

secondly by estimating the relationships with both Ordered Probit models and

Ordered Logit models (to allow more flexibility in the behaviour of the error

term, since we omitted multiplicative heteroskedasticity).

In our analyses, the observed spread, K

t

, is similarly assumed to take on only a

fixed number of discrete values, a

1

, a

2

, … a

J

, but the unobservable continuous

random variable, K*, is defined by

K

*

t

= X

i

’| + c

(10)

where c is i.i.d. standard normal for the Ordered Probit model, and takes the

form of the logistic distribution for the Ordered Logit model.

The ordered response models relate the observed spreads to K* via

(11)

where the A

j

’s form an ordered partition of the real line into J disjoint intervals.

32

The probability that the spread takes on the value a

j

is equal to the probability

that K* falls into the appropriate partition, A

j

.

For tractability reasons, B&M based the empirical analysis on a classification of

the spread into only four different categories. From the distribution of spreads of

the USD/DEM in 1989, the four most commonly observed spreads account for

97.0 percent of the total quotes.

USD/DEM

Frequency Distribution fof Spreads

Spread All Quotes

0 < . < 5 2,304 (0.8%)

5 77,856 (25.6%)

5 < . < 7 607 (0.2%)

7 34,878 (11.5%)

7 < . < 10 2,977 (1.0%)

10 170,892 (56.1%)

10 < . < 15 329 (0.1%)

15 11,534 (3.8%)

15 < . < 20 39 (0.0%)

20 2,616 (0.9%)

20 < . 572 (0.2%)

Note: Spreads converted into basis points

Table 2: Distribution of Spreads of USD/DEM April-June 1989

We also performed the ordered response analyses with four ordered indicator

values. In addition, as we will see later, because the spreads distribution for the

USD/SGD 2006 and 2009 data have more converging points (certain spread

sizes where there are more quotes than others) than both the USD/DEM and the

USD/SGD in 1989, we used up to 10 ordered indicator values in our own

33

ordered response analyses.

In the case of B&M where by four ordered indicator values of a

j

’s were used, the

corresponding intervals for the unobservable latent variable K* are defined by:

(12)

The partition parameters, µ

I

, are estimated jointly with the other parameters of

the model.

The ordered response model defined above allows us to estimate the probability

of a particular spread being observed as a function of the predetermined

variables, X

t

. In order to test the hypothesis that the spread is partly determined

by the volatility of the spot rate, the GARCH estimate of the conditional

variance for the ask prices is included as one of the elements in X

t

.

B&M noted that Bollerslev and Domowitz (1993) indicated a distinct intra-day

pattern in the spread distribution and tt is possible that any significant effect of

the conditional variance in isolation may merely reflect this dependence rather

than provide an independent influence on the spread process. In order to take

34

account of this own temporal dependence, K

t-1

was included as an element of the

X

t

vector in the estimation of the ordered response functions for K*

t

:

K

t

* = o

1

o

A,t

2

+ o

2

K

t-1

+ c (13)

Given the partition boundaries determined by the data, if a higher conditional

mean o'X, is caused by a larger conditional variance of the spot rate, and this

raises the probability of observing a higher spread, we will infer that the

hypothesized theoretical link is supported by the empirical analysis.

We now describe each of the datasets in more details in the following section:

3.2 Description of the Data

We purchased four sets of data from Olsen Financial Technologies GmbH:

a. Dataset 1 – USD/DEM quotes from April 1989 to June 1989

b. Dataset 2 – USD/SGD quotes from April 1989 to June 1989

c. Dataset 3 – USD/SGD quotes from April 2006 to May 2006

d. Dataset 4 – USD/SGD quotes from April 2009 to May 2009

Dataset 1: USD/DEM from April 1989 to June 1989

For the first dataset we purchased the same dataset used by B&M – USD-DEM

quotes from April 1989 to June 1989. We wanted to repeat the empirical analysis

35

on the dataset again to allow for an apples-to-apples comparison between the

USD/DEM 1989 and the USD/SGD 1998 results.

First, B&M’s results were obtained in 1993 using probably not so

technologically advanced means. We wanted to repeat the estimation processes

again using EViews. Furthermore, as mentioned in the previous Chapter, we

departed from B&M’s ordered probit procedure by omitting multiplicative

heteroskedasticity. Second, B&M’s data were obtained from Reuters. From their

paper we were unable to ascertain the accuracy of this data, or how they

presented 12 workweeks of data from an actual 13 weeks in April to June 1989.

We obtained ours by purchasing from Olsen Financial Technologies GmbH and

upon comparison, we found some minor differences. The differences between

our purchased data and the actual data used by B&M are tabulated as follows:

a. Volume of Quotes

ORIGINAL BOLLERSLEV & MELVIN PURCHASED FROM OLSENDATA

DAY TICKS DAY TICKS

Sun 887 0.29% Sun 1,571 0.51%

Mon 60,095 19.66% Mon 56,600 18.25%

Tue 66,109 21.63% Tue 67,634 21.80%

Wed 63,812 20.88% Wed 66,325 21.38%

Thu 61,521 20.13% Thu 61,377 19.79%

Fri 53,082 17.37% Fri 56,646 18.26%

Sat 98 0.03% Sat 33 0.01%

Grand Total 305,604 100.00% Grand Total 310,186 100.00%

Table 3: Quote Volume differences between B&M and Purchased Data USD/DEM 1989

B&M collected 305,604 ticks of USD/DEM quotes while the dataset purchased

from Olsen Financial Technologies GmbH contains 310,186 ticks. The

distribution of the quotes over each workday is similar in terms of percentage in

both datasets.

36

b. Frequency of No Spread Change

USD/DEM

No. of Quotes, & Frequency of No Spread Change

No Change in Spread

Number Bid-Ask Rise Bid-Ask Fall

All quotes 304,619 8.00% 8.30%

Table 4: Frequency of No Spread Change reported by B&M USD/DEM 1989

B&M reported that 8% of all the quotes observed no change in spread when the

bid-ask price rose and that 8.3% of all the quotes observed no change in spread

when the bid-ask price fell. It was not clear, however, whether these percentages

where calculated based on Number of Ticks with No Spread Change divided by

Number of Ticks Moved, or on Number of Ticks with No Spread Change

divided by Total Number of Ticks. We make this distinction clearer with the

purchased data.

SPREAD SPREAD SPREAD

UP SAME DOWN

PRICE UP 64384 32787 23767

PRICE SAME 13083 39422 13523

PRICE DOWN 24045 33407 64164

Grand Total 101512 105616 101454

SPREAD SPREAD SPREAD

UP SAME DOWN

PRICE UP 53.24% 27.11% 19.65%

PRICE SAME 19.81% 59.70% 20.48%

PRICE DOWN 19.77% 27.47% 52.76%

GRAND TOTAL 32.90% 34.23% 32.88%

SPREAD SPREAD SPREAD

UP SAME DOWN

PRICE UP 20.86% 10.63% 7.70%

PRICE SAME 4.24% 12.78% 4.38%

PRICE DOWN 7.79% 10.83% 20.79%

GRAND TOTAL 32.90% 34.23% 32.88%

NO. OF QUOTES

DIVIDED BY NO OF TICKS MOVED

DIVIDED BY TOTAL NO. OF TICKS

Table 5: Frequency of No Spread Change with Olsen USD/DEM 1989

Among all ticks, we counted that 10.63% and 10.83% of all ticks observed no

change in spreads when the price rose and fell respectively.

37

c. Frequency Distribution of Spreads

Frequency Distribution of Spreads

Spread

0 < . < 5 2,304 (0.8%) 2,562 (0.8%)

5 77,856 (25.6%) 81,368 (26.4%)

5 < . < 7 607 (0.2%) 660 (0.2%)

7 34,878 (11.5%) 35,682 (11.6%)

7 < . < 10 2,977 (1.0%) 3,192 (1.0%)

10 170,892 (56.1%) 171,264 (55.5%)

10 < . < 15 329 (0.1%) 327 (0.1%)

15 11,534 (3.8%) 10,389 (3.4%)

15 < . < 20 39 (0.0%) 38 (0.0%)

20 2,616 (0.9%) 2,547 (0.8%)

20 < . 572 (0.2%) 553 (0.2%)

ORIGINAL OLSENDATA

Note: Spreads converted into basis points

Table 6: Frequency Distribution of Spreads USD/DEM 1989

It appears that the frequency distribution of spreads is quite similar between the

dataset reported by B&M and the dataset purchased from Olsen Financial

Technologies GmbH. The most common bid-ask spread is 10 basis points,

followed by 5 basis points.

Dataset 2: USD/SGD from April 1989 to June 1989

The second dataset are USD/SGD quotes from April 1989 to June 1989.

a. Volume of Quotes

DAY USD/SGD

Sun 6 0.07%

Mon 1,307 15.43%

Tue 2,024 23.89%

Wed 1,876 22.14%

Thu 1,652 19.50%

Fri 1,586 18.72%

Sat 21 0.25%

Grand Total 8,472 100.00%

Table 7: Volume of Quotes of USD/SGD April-June 1989

Compared against a major currency in 1989 over the same period from April to

June, there are only 8,472 USD/SGD quotes compared to over 310,000 for the

USD/DEM. Distribution of the quotes over the week are however quite similar,

38

with volume peaking during midweek.

b. Frequency of No Spread Change

Compared against the USD/DEM in 1989 over the same period from April to

June, we do not observe as much spread changes in the USD/SGD when prices

moves. When prices move upwards, the spread remained unchanged 89.21% of

the time. When prices move downwards, the spread remained unchanged

90.62% of the time.

SPREAD SPREAD SPREAD

UP SAME DOWN

PRICE UP 87 3108 289

PRICE SAME 62 1340 63

PRICE DOWN 256 3168 72

Grand Total 405 7616 424

SPREAD SPREAD SPREAD

UP SAME DOWN

PRICE UP 2.50% 89.21% 8.30%

PRICE SAME 4.23% 91.47% 4.30%

PRICE DOWN 7.32% 90.62% 2.06%

GRAND TOTAL 4.80% 90.18% 5.02%

SPREAD SPREAD SPREAD

UP SAME DOWN

PRICE UP 1.03% 36.80% 3.42%

PRICE SAME 0.73% 15.87% 0.75%

PRICE DOWN 3.03% 37.51% 0.85%

GRAND TOTAL 4.80% 90.18% 5.02%

NO. OF QUOTES

DIVIDED BY NO OF TICKS MOVED

DIVIDED BY TOTAL NO. OF TICKS

Table 8: Frequency of No Spread Change for USD/SGD April-June 1989

39

c. Frequency Distribution of Spreads

Frequency Distribution of Spreads

Spread

0 < . < 5 6 (0.1%)

5 137 (1.6%)

5 < . < 7 22 (0.3%)

7 122 (1.4%)

7 < . < 10 43 (0.5%)

10 7,854 (93.0%)

10 < . < 15 6 (0.1%)

15 76 (0.9%)

15 < . < 20 1 (0.0%)

20 164 (1.9%)

20 < . 14 (0.2%)

USD/SGD

Note: Spreads converted into basis points

Table 9: Frequency Distribution of Spreads USD/SGD April-June 1989

While spread changes in the USD/SGD are uncommon when prices moves, we

note similar characteristics to the USD/DEM in that the most common bid-ask

spread is 10 basis points. When spreads do change, they are most likely to be 5,

7 or 20 basis points.

Dataset 3: USD/SGD from April 2006 to May 2006

The third dataset are USD/SGD quotes from April 2006 to May 2006.

a. Volume of Quotes

DAY USD/SGD

Sun 3,832 0.63%

Mon 104,327 17.24%

Tue 126,812 20.96%

Wed 147,084 24.31%

Thu 135,037 22.32%

Fri 87,332 14.44%

Sat 555 0.09%

Grand Total 604,979 100.00%

Table 10: Volume of Quotes of USD-SGD April-May 2006

15 years later, the USD/SGD has grown to become a major currency in

Southeast Asia. Compared against itself in 1989 over the period from April to

May, the volume of quotes of the USD/SGD has grown from over 8,400 ticks in

40

3 months to over 604,000 ticks in 2 months. The distribution of quotations over

the week remains consistent with volume peaking during midweek.

b. Frequency of No Spread Change

In 2006, we observed that the tendency for spreads to remain unchanged when

prices move is reduced dramatically. Now, when prices move upwards, the

spread remained unchanged only 14.99% of the time compared to 89.21% of the

time in 1989. When prices move downwards, the spread remained unchanged

only 15.46% of the time compared to 90.62% of the time in 1989.

SPREAD SPREAD SPREAD

UP SAME DOWN

PRICE UP 194955 38121 21197

PRICE SAME 24340 45185 20568

PRICE DOWN 19302 39611 197313

Grand Total 238597 122917 239078

SPREAD SPREAD SPREAD

UP SAME DOWN

PRICE UP 76.67% 14.99% 8.34%

PRICE SAME 27.02% 50.15% 22.83%

PRICE DOWN 7.53% 15.46% 77.01%

GRAND TOTAL 39.73% 20.47% 39.81%

SPREAD SPREAD SPREAD

UP SAME DOWN

PRICE UP 32.46% 6.35% 3.53%

PRICE SAME 4.05% 7.52% 3.42%

PRICE DOWN 3.21% 6.60% 32.85%

GRAND TOTAL 39.73% 20.47% 39.81%

NO. OF QUOTES

DIVIDED BY NO OF TICKS MOVED

DIVIDED BY TOTAL NO. OF TICKS

Table 11: Frequency of No Spread Change for USD-SGD April-May 2006

41

c. Frequency Distribution of Spreads

Frequency Distribution of Spreads

Spread

0 < . < 5 51,090 (8.5%)

5 224,763 (37.2%)

5 < . < 7 51,163 (8.5%)

7 68,377 (11.3%)

7 < . < 10 53,582 (8.9%)

10 155,466 (25.7%)

10 < . < 15 25 (0.0%)

15 17 (0.0%)

15 < . < 20 15 (0.0%)

20 1 (0.0%)

20 < . 0 (0.0%)

USD/SGD

Note: Spreads converted into basis points

Table 12: Frequency Distribution of Spreads USD-SGD April-June 2006

The characteristics of the frequency distribution of spreads have also changed

almost completely over 15 years. The most common spread in 2006 is 5 basis

points, followed by 10 basis points. Most of the spreads recorded are either 10

basis points or lower, while quotes with spreads of more than 10 basis points

make up less than 0.01% of the entire spectrum of quotes.

Dataset 4: USD/SGD from April 2009 to May 2009

The fourth dataset are USD/SGD quotes from April 2009 to May 2009.

a. Volume of Quotes

DAY USD/SGD

Sun 9,336 0.87%

Mon 183,055 17.02%

Tue 217,496 20.22%

Wed 237,508 22.08%

Thu 237,604 22.09%

Fri 190,603 17.72%

Sat 32 0.00%

Grand Total 1,075,634 100.00%

Table 13: Volume of Quotes of USD/SGD April-May 2009

In the year of the 2009 economic crisis, we observed a dramatic increase in

volume of USD-SGD quotes over the period of April to May 2009, as compared

to the same period in 2006, although we noted earlier that the volume growth

42

had been exponential since 2002. The volume of quotes of the USD-SGD has

grown from over 604,000 ticks, to exceeding 1 million quotes over a 2 month

period.

b. Frequency of No Spread Change

We now observed that in 2009, the tendency for spreads to remain unchanged

when prices moved is reduced again compared to 2006. Now, when prices move

upwards, the spread remained unchanged 10.17% of the time compared to

14.99% of the time in 1989. When prices move downwards, the spread remained

unchanged 9.76% of the time compared to 15.46% of the time in 2006.

SPREAD SPREAD SPREAD

UP SAME DOWN

PRICE UP 304279 48129 120968

PRICE SAME 59290 18050 53790

PRICE DOWN 120972 45055 295733

Grand Total 484541 111234 470491

SPREAD SPREAD SPREAD

UP SAME DOWN

PRICE UP 64.28% 10.17% 25.55%

PRICE SAME 45.21% 13.76% 41.02%

PRICE DOWN 26.20% 9.76% 64.04%

GRAND TOTAL 45.44% 10.43% 44.13%

SPREAD SPREAD SPREAD

UP SAME DOWN

PRICE UP 28.54% 4.51% 11.35%

PRICE SAME 5.56% 1.69% 5.04%

PRICE DOWN 11.35% 4.23% 27.74%

GRAND TOTAL 45.44% 10.43% 44.13%

DIVIDED BY NO OF TICKS MOVED

DIVIDED BY TOTAL NO. OF TICKS

NO. OF QUOTES

Table 14: Frequency of No Spread Change for USD-SGD April-May 2009

43

c. Frequency Distribution of Spreads

Frequency Distribution of Spreads

Spread

<2.00 13 (0.0%)

2 13,684 (1.3%)

2.00 < . < 3.00 8,422 (0.8%)

3 54,432 (5.1%)

3.2 20,407 (1.9%)

3.20 < . < 3.50 6,484 (0.6%)

3.5 114,907 (10.7%)

3.50 < . < 4.00 10,882 (1.0%)

4 88,441 (8.2%)

4.00 < . < 5.00 13,748 (1.3%)

5 59,572 (5.5%)

5.00 < . < 6.00 6,932 (0.6%)

6 54,354 (5.1%)

6.00 < . < 7.00 2,903 (0.3%)

7 165,828 (15.4%)

7.00 < . < 8.00 2,080 (0.2%)

8 268,577 (25.0%)

8.00 < . < 9.00 1,158 (0.1%)

9 39,789 (3.7%)

9.00 < . < 10.00 830 (0.1%)

10 91,613 (8.5%)

10.00 < . < 11.00 579 (0.1%)

11 11,304 (1.1%)

> 11.00 38,696 (3.6%)

USD/SGD

Note: Spreads converted into basis points

Table 15: Frequency Distribution of Spreads USD-SGD April-May 2009

The characteristics of the frequency distribution of spreads have changed again

over 3 years. The most common spread in 2006 was 5 basis points, followed by

10 basis points. In 2009, the most common spread had risen to 8 basis points,

followed by 7 basis points and 3.5 basis points respectively. Most of the spreads

recorded are still either 10 basis points or lower, but quotations with spreads of

more than 10 basis points have increased to slightly under 5% of the entire

spectrum of quotations.

Two observations are of noteworthy regarding the 2009 dataset. First, the most

common spreads are no longer “significant” numbers such as 5 or 10. This could

indicate advancement in the market’s ability to evaluate foreign exchange risk,

44

and hence being able to price bids and asks more accurately. Second, the volume

of quotes with spreads of more than 10 basis points increased from 0.01% in

2006 to slightly under 5% in 2009. This could be attributed to the increased

amount of uncertainty in the financial markets during that period of global

economic crisis. Both phenomena could warrant future research.

3.3 GARCH Analysis

The primary purpose of the GARCH estimation was to create proxies for the

conditional variance of the exchange rate to be used in the investigation of the

determinants of the spread. Recall from Section 3.1 that, following B&M, we

estimate for each dataset with the following MA(1)-GARCH(1,1) model:

(7)

where I

t-1

denotes the time t-1 information set, and µ, u, e, o, and | are the

parameters to be estimated. The time t subscript refers to the place in the order

of the series of quotes, so that o

A,t

2

provides an estimate of the price volatility

between quotes.

Following B&M, we first removed all weekend quotes. We then used EViews to

estimate the parameters for each dataset and the full results are attached in

45

Appendix 1. Here we present a summary of the results:

B&M

DEM1989 DEM1989 SGD1989 SGD2006 SGD2009

µ 0.0065 0.0069 0.0452 0.0025 0.0023

(0.0042) (0.0013) (0.0138) (0.0004) (0.0003)

u -0.5953 -0.5867 -0.3281 -0.7817 -0.7802

(0.0052) (0.0014) (0.0114) (0.0009) (0.0006)

e 0.1008 0.0500 0.6833 0.0578 0.0453

(0.0053) (0.0005) (0.0256) (0.0008) (0.0002)

o 0.0652 0.0561 0.2650 0.0632 0.0513

(0.0018) (0.0003) (0.0081) (0.0006) (0.0002)

| 0.9057 0.9327 0.6540 0.9025 0.9197

(0.0030) (0.0003) (0.0075) (0.0009) (0.0003)

o+| 0.9708 0.9888 0.9190 0.9657 0.9710

T 304,608 308,748 8,444 551,355 1,006,736

Asymptotic errors are reported in parenthesis

Table 16: GARCH Estimates for all Datasets

The first column contains the average of the weekly estimates from the original

B&M dataset (they only estimated these parameters per workweek, for 12

weeks). The second to fifth columns contain the EViews GARCH estimates for

the parameters for the purchased USD/DEM 1989, USD/SGD 1989, USD/SGD

2006, and USD/SGD 2009 data respectively.

First we observe that the EViews estimates for the purchased USD/DEM dataset

compares very well with B&M’s original results, though standard errors are

significantly lower. This provides confidence that the EViews results for the rest

of the datasets are appropriate for comparison.

46

The second observation is that all estimates for u are negative, which

corresponds to B&M’s results, and they noted that “the negative estimates for u

may be partly attributed to a non-synchronous quoting phenomenon; see Lo and

MacKinlay (1990) for a formal analysis.”

The GARCH effects for all datasets are all highly significant. Comparing

GARCH effects between the USD/DEM 1989 dataset and USD/SGD 1989

dataset, it is clear that the USD/DEM dataset shows much stronger effects, and

stronger o+| volatility persistence. This is expected, as the USD/DEM dataset

contains at least 36 times more observations and from Table 8, the spread did not

change 90.18% of the time.

As the Singapore economy grows and the USD/SGD becomes a significant

regional currency, the results show that the GARCH effects and persistence of

volatility is consistent with this phenomenon.

The primary purpose of the GARCH estimation was to create proxies for the

conditional variance of the exchange rate to be used in the investigation of the

determinants of the spread. To this end, we used EViews to obtain GARCH

variance series for each dataset.

47

3.4 Ordered Response Analysis

Recall from Section 3.1 that we estimate for each dataset with the following

ordered response model (probit and logit):

K

t

* = o

1

o

A,t

2

+ o

2

K

t-1

+ c (13)

We first use four ordered indicator values and B&M’s definitions for a

j

’s:

a

1

: <= 5 a

2

: 5 < . < 10 a

3

: = 10 a

4

: > 10

The results for the above parameters for all four datasets are attached in

Appendix 1, but a summary is presented below:

DEM1989 SGD1989 SGD2006 SGD2009

o1 0.0214 0.0091 0.0464 0.0988

(73.9604) (10.6719) (29.2412) (113.8863)

o2 0.3116 0.0422 -0.1306 0.2622

(135.3568) (22.3298) -(69.4622) (177.1729)

T 308,748 8,444 551,355 1,006,736

Z-statistics are reported in parenthesis

Table 17: Ordered Probit Estimates for all Datasets (4 ordered indicator values)

DEM1989 SGD1989 SGD2006 SGD2009

o1 0.1299 0.0231 0.0802 0.2146

(102.6436) (9.2342) (28.9306) (109.5740)

o2 0.4330 1.8160 -0.2040 0.4395

(108.2955) (23.1592) -(66.7912) (169.4684)

T 308,748 8,444 551,355 1,006,736

Z-statistics are reported in parenthesis

Table 18: Ordered Logit Estimates for all Datasets (4 ordered indicator values)

48

The positive o

1

coefficients for both ordered probit and logit analyses above

suggest that there is a significantly positive effect of exchange rate volatility on

the spread for all datasets. The conditional mean of K

t

* is an increasing function

of o

A,t

2

. This is consistent with the implications drawn from B&M’s theoretical

model. The estimates for o

2

are indicative of intra-day persistence in the spread

process.

The magnitude of o

1

for each dataset supports what we intuitively already know.

Comparing the USD/DEM and USD/SGD in 1989, although both o

1

values are

statistically significant, volatility appears to play a much larger role in

determining the size of the spread for the USD/DEM. After all, as noted above,

the spread remained the same 90.18% of the time for the USD/SGD in 1989. For

the same reason, the o

2

values show that the dependence on the previous spread

appears to be more significant for the USD/SGD than for the USD/DEM.

As the country grow in economic significance and the SGD becoming a major

regional currency over 17 years, the magnitude of the o

1

values almost

quadrupled, coincidentally matching the growth in quote volume. It is

interesting to note the negative o

2

values for the USD/SGD 2006 dataset, but it

might be due to seasonality.

49

In 2009, in midst of the worldwide financial crisis, we observed a higher level of

volatility in the USD/SGD. The much higher o

1

values for this dataset, together

with the larger distribution of spreads as shown in Table 15, supports the theory

that the bid-ask spreads of foreign exchange rates is very much positively related

to the underlying volatility.

We repeated the ordered response analyses using 10 ordered indicator values,

due to the larger distribution of spreads as seen in the 2006 and 2009 data. The

a

j

’s are:

a

1

: < 3 a

2

: 3 <= . < 4 a

3

: 4 <= . < 5

a

4

: 5 <= . < 6 a

5

: 6 <= . < 7 a

6

: 7 <= . < 8

a

7

: 8 <= . < 9 a

8

: 9 <= . < 10 a

9

: = 10

a

10

: > 10

Again, the results for the above parameters for all four datasets are attached in

Appendix 1, but a summary is presented below:

DEM1989 SGD1989 SGD2006 SGD2009

o1 0.0345 0.0106 0.0296 0.0964

(90.1741) (12.7664) (19.2017) (117.0911)

o2 0.1124 0.2933 -0.0404 0.0884

(122.5758) (16.0766) -(61.5938) (212.8967)

T 308,748 8,444 551,355 1,006,736

Z-statistics are reported in parenthesis

Table 19: Ordered Probit Estimates for all Datasets (10 ordered indicator values)

50

DEM1989 SGD1989 SGD2006 SGD2009

o1 0.1557 0.0305 0.0599 0.2047

(115.2591) (10.8283) (22.1246) (110.9948)

o2 0.1599 0.5637 -0.0755 0.1493

(100.3382) (16.7295) -(67.7863) (205.0571)

T 308,748 8,444 551,355 1,006,736

Z-statistics are reported in parenthesis

Table 20: Ordered Logit Estimates for all Datasets (10 ordered indicator values)

Generally, the conclusions from the previous ordered response analyses with 4

ordered indicator values still holds after we attempt to be more discerning with

the ordered indicator values.

3.5 Incorporating Returns

Recall that we noted (see Tables 5, 11 and 14) an interesting phenomenon

regarding the behavior of bid-ask spreads of foreign exchange rates. When

prices move up, and the bid-ask spreads change, they tend to widen. Conversely,

when prices move down, and the bid-ask spreads change, they tend to narrow.

Previously we were examining the relationship between bid-ask spreads and the

underlying volatility of exchange rates and found that positive relationships

generally exists between the two. We are now curious if there is any relationship

between bid-ask spreads and price movement. To examine this we repeat the

ordered response analyses by including the Returns variable from the

MA(1)-GARCH(1,1) model into the ordered response model:

51

K

t

* = o

1

o

A,t

2

+ o

2

K

t-1

+ o

3

10,000*AlogA

t

+ c (14)

We repeated the ordered probit and ordered logit analyses for all four datesets

using both 4 and 10 ordered indicator values. The results are attached in

Appendix 1, but we summarize the results below:

DEM1989 SGD1989 SGD2006 SGD2009

o1 0.0148 0.0093 0.0325 0.0406

(51.4649) (10.9454) (19.1288) (44.7718)

o2 0.0383 1.0090 0.5203 0.2606

(16.2662) (23.4338) (210.7702) (146.0215)

o3 0.0970 0.0827 0.6241 0.4158

(98.3419) (12.2743) (449.5486) (437.6876)

T 308,748 8,444 551,355 1,006,736

Z-statistics are reported in parenthesis

Table 21: Ordered Probit Estimates (with Returns) for all Datasets (4 ordered values)

DEM1989 SGD1989 SGD2006 SGD2009

o1 0.1319 0.0235 0.0485 0.2225

(101.6830) (8.7724) (14.8530) (96.1127)

o2 0.6732 1.9380 1.0532 1.9644

(154.6104) (24.1228) (229.6602) (494.6543)

o3 0.3205 0.1796 1.2152 1.3865

(174.0656) (12.2520) (409.7483) (585.1713)

T 308,748 8,444 551,355 1,006,736

Z-statistics are reported in parenthesis

Table 22: Ordered Logit Estimates (with Returns) for all Datasets (4 ordered values)

52

DEM1989 SGD1989 SGD2006 SGD2009

o1 0.0205 0.0108 -0.0350 -0.0032

(54.0252) (13.0826) -(22.6917) -(3.8439)

o2 0.0042 0.3135 0.0185 0.0949

(4.5016) (17.0041) (22.5621) (188.9157)

o3 0.0961 0.0745 0.0012 0.3996

(105.6836) (11.3375) (298.6273) (468.5108)

T 308,748 8,444 551,355 1,006,736

Z-statistics are reported in parenthesis

Table 23: Ordered Probit Estimates (with Returns) for all Datasets (10 ordered values)

DEM1989 SGD1989 SGD2006 SGD2009

o1 0.1592 0.0317 0.0673 0.2688

(113.7732) (10.6241) (21.1859) (124.5891)

o2 0.2532 0.6059 0.4030 0.5755

(146.3672) (17.7207) (251.9007) (574.3314)

o3 0.3182 0.1677 1.1891 1.2835

(173.2477) (11.3873) (434.4841) (654.4871)

T 308,748 8,444 551,355 1,006,736

Table 24: Ordered Logit Estimates (with Returns) for all Datasets (10 ordered values)

In general (except for Ordered Probit estimates for 10 ordered values), the

results for o

1

and o

2

values are consistent with the results in the previous section.

Even when taking Returns into account, B&M’s theory still holds. The results

for o

3

values show that a significant positive relationship also exists between the

size of the bid-ask spread and the direction of the exchange rate movement.

53

One interesting result to note are the negative o

1

and o

2

values for the ordered

probit analyses of 2006 and 2009 for 10 ordered indicator values (see Table 23).

Not only does this violate B&M’s prediction, the observation that the o

1

values

appear to decrease with increasing tick volume runs counter to the rest of the

ordered response results. One possible explanation for this is that multiplicative

heteroskedasticity, which our ordered response models omitted but has been

shown to be significant by B&M, is likely to be the cause of this results.

Also since we know that the error term of equations 13 and 14 are not i.d.d.

standard normal, the results for the ordered logit analyses are probably more

meaningful.

3.6 Summary

B&M provided the theoretical framework and showed empirical evidence that

the size of the bid-ask spread of exchange rates is positively related to the

exchange rate’s underlying volatility. Their empirical subject was over 300,000

USD/DEM quotes from April to June of 1989. The USD/DEM was obviously

one of the most traded currency pair during that time, and both the USD and

DEM belonged to floating exchange rates regimes of two of the top three largest

world economies in 1989.

54

We then wanted to see if both theory and empirical results would hold for a

much lesser traded subject currency, if the currency belonged to a small country

and from a semi-floating exchange rate regime – the USD/SGD.

We applied a modified version of B&M’s methodology on the USD/SGD from

the same months of April to June 1989 and found that the evidence (as

documented in the previous section) supported their theory. Furthermore, we

repeated the analysis on the USD/SGD 17 years later in 2006 when the world

economy was at a point of stability, and again in 2009 when the world economy

was somewhat in disarray. We found that B&M’s theory was still supported by

the evidence.

Along the way we also noted the interesting phenomenon regarding the behavior

of bid-ask spreads of foreign exchange rates. When prices move up, and the

bid-ask spreads change, they tend to widen. Conversely, when prices move

down, and the bid-ask spreads change, they tend to narrow. We repeated the

analyses on the datasets and included Returns as additional variable in the

ordered response models. We found that the relationship between bid-ask

spreads and price direction is positive and significant.

55

4 Conclusion

This paper has set out to empirically test B&M’s theory against a lesser-traded

currency from a developing country with a managed floating rate regime. The

results generally hold, and we found that the effects of the tested parameters

grew in strength as that currency grew in economic significance in its region.

We departed from B&M’s methodology by omitting multiplicative

heteroskedasticity, but we tested our data using both Ordered Probit and Ordered

Logit models. The generally “better-behaving” results from the Logit models

suggests that the disturbances are indeed not standard normal, and that future

work in this area using the same methodologies should include multiplicative

heteroskedasticity.

We also noted the interesting phenomenon regarding the behavior of bid-ask

spreads of foreign exchange rates. We included returns as additional variable in

the ordered response models and found that the relationship between bid-ask

spreads and price direction is positive and significant. Future work in this area

should attempt to build a model which links bid-ask spreads not only to

volatility and also returns.

We provided a simple survey on microstructure literature. We first touched on

those which analyses bid-ask spreads and asymmetric information, and also

56

presented snapshots of research involving bid-ask spreads and volatility. Bid-ask

spreads, one of two “hallmarks” of the microstructure approach, remain a

popular theme for research today.

57

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60

Appendix 1 – EViews Results

A.1.1 Dataset 1: USD-DEM April 1989 to June 1989:

A.1.1.1 MA(1)-GARCH(1,1) Results:

Dependent Variable: 10000*DLOG(ASK)

Method: ML - ARCH (Marquardt) - Normal distribution

Sample (adjusted): 2 304131

Included observations: 304130 after adjustments

Convergence achieved after 86 iterations

MA Backcast: 1

Presample variance: backcast (parameter = 0.7)

GARCH = C(3) + C(4)*RESID(-1)^2 + C(5)*GARCH(-1)

Variable Coefficient Std. Error z-Statistic Prob.

C 0.007732 0.001186 6.518723 0

MA(1) -0.586985 0.00129 -455.0911 0

Variance Equation

C 0.04555 0.000523 87.1623 0

RESID(-1)^2 0.055817 0.00029 192.773 0

GARCH(-1) 0.934608 0.000278 3358.51 0

R-squared 0.237055 Mean dependent var 0.00087

Adjusted R-squared 0.237053 S.D. dependent var 2.379553

S.E. of regression 2.078464 Akaike info criterion 4.102756

Sum squared resid 1313837 Schwarz criterion 4.102931

Log likelihood -623880.6 Hannan-Quinn criter. 4.102807

Durbin-Watson stat 1.942352

Inverted MA Roots 0.59

61

A.1.1.2 Ordered Probit Results: 4 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Probit (Quadratic hill climbing)

Sample (adjusted): 2 304131

Included observations: 304130 after adjustments

Number of ordered indicator values: 4

Convergence achieved after 4 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.021372 0.000289 73.96036 0

AJ(-1) 0.311626 0.002302 135.3568 0

Limit Points

LIMIT_2:C(3) 0.190472 0.005775 32.98297 0

LIMIT_3:C(4) 0.557843 0.005798 96.21363 0

LIMIT_4:C(5) 2.633627 0.007509 350.7163 0

Pseudo R-squared 0.041442 Akaike info criterion 2.077312

Schwarz criterion 2.077487 Log likelihood -315881.5

Hannan-Quinn criter. 2.077363 Restr. log likelihood -329538.1

LR statistic 27313.29 Avg. log likelihood -1.03864

Prob(LR statistic) 0

62

A.1.1.3 Ordered Probit (with Returns) Results: 4 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Probit (Quadratic hill climbing)

Sample (adjusted): 2 304131

Included observations: 304130 after adjustments

Number of ordered indicator values: 4

Failure to improve Likelihood after 12 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.014821 0.000288 51.46485 0

AJ(-1) 0.038314 0.002355 16.26616 0

10000*DLOG(ASK) 0.096973 0.000986 98.34188 0

Limit Points

LIMIT_2:C(4) -0.569596 0.005843 -97.47589 0

LIMIT_3:C(5) -0.204094 0.005933 -34.39776 0

LIMIT_4:C(6) 1.828335 0.007386 247.5462 0

Pseudo R-squared 0.041202 Akaike info criterion 2.077839

Schwarz criterion 2.078049 Log likelihood -315960.6

Hannan-Quinn criter. 2.0779 Restr. log likelihood -329538.1

LR statistic 27155.04 Avg. log likelihood -1.0389

Prob(LR statistic) 0

63

A.1.1.4 Ordered Probit Results: 10 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Probit (Quadratic hill climbing)

Sample (adjusted): 2 308749

Included observations: 307943 after adjustments

Number of ordered indicator values: 10

Convergence achieved after 7 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.034469 0.000382 90.17413 0

AJ(-1) 0.112367 0.000917 122.5758 0

Limit Points

LIMIT_2:C(3) -2.206482 0.01721 -128.2094 0

LIMIT_3:C(4) -1.756869 0.010998 -159.7475 0

LIMIT_4:C(5) -1.538779 0.00944 -162.9984 0

LIMIT_5:C(6) 0.322974 0.006894 46.85067 0

LIMIT_6:C(7) 0.329696 0.006894 47.8258 0

LIMIT_7:C(8) 0.666276 0.006924 96.2254 0

LIMIT_8:C(9) 0.693844 0.006929 100.1396 0

LIMIT_9:C(10) 0.694678 0.006929 100.2579 0

LIMIT_10:C(11) 2.788901 0.008505 327.928 0

Pseudo R-squared 0.037526 Akaike info criterion 2.258734

Schwarz criterion 2.259114 Log likelihood -347769.7

Hannan-Quinn criter. 2.258844 Restr. log likelihood -361329

LR statistic 27118.64 Avg. log likelihood -1.129331

Prob(LR statistic) 0

64

A.1.1.5 Ordered Probit (with Returns) Results: 10 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Probit (Quadratic hill climbing)

Sample (adjusted): 2 308749

Included observations: 307943 after adjustments

Number of ordered indicator values: 10

Failure to improve Likelihood after 9 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.020522 0.00038 54.02521 0

AJ(-1) 0.004221 0.000938 4.501637 0

10000*DLOG(ASK) 0.096148 0.00091 105.6836 0

Limit Points

LIMIT_2:C(4) -3.04669 0.017039 -178.812 0

LIMIT_3:C(5) -2.605993 0.011008 -236.7287 0

LIMIT_4:C(6) -2.393098 0.00953 -251.1147 0

LIMIT_5:C(7) -0.605194 0.006997 -86.49427 0

LIMIT_6:C(8) -0.598756 0.006998 -85.56097 0

LIMIT_7:C(9) -0.277872 0.007077 -39.26293 0

LIMIT_8:C(10) -0.251959 0.007086 -35.55753 0

LIMIT_9:C(11) -0.251127 0.007086 -35.43857 0

LIMIT_10:C(12) 1.820135 0.008402 216.6283 0

Pseudo R-squared 0.034829 Akaike info criterion 2.26507

Schwarz criterion 2.265485 Log likelihood -348744.3

Hannan-Quinn criter. 2.26519 Restr. log likelihood -361329

LR statistic 25169.41 Avg. log likelihood -1.132496

Prob(LR statistic) 0

65

A.1.1.6 Ordered Logit Results: 4 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Logit (Quadratic hill climbing)

Sample (adjusted): 2 304131

Included observations: 304130 after adjustments

Number of ordered indicator values: 4

Convergence achieved after 4 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.129908 0.001266 102.6436 0

AJ(-1) 0.432993 0.003998 108.2955 0

Limit Points

LIMIT_2:C(3) 0.483887 0.009847 49.14077 0

LIMIT_3:C(4) 1.100335 0.009948 110.6037 0

LIMIT_4:C(5) 4.89648 0.014927 328.0225 0

Pseudo R-squared 0.051821 Akaike info criterion 2.05482

Schwarz criterion 2.054994 Log likelihood -312461.1

Hannan-Quinn criter. 2.05487 Restr. log likelihood -329538.1

LR statistic 34153.96 Avg. log likelihood -1.027393

Prob(LR statistic) 0

66

A.1.1.7 Ordered Logit (with Returns) Results: 4 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Logit (Quadratic hill climbing)

Sample (adjusted): 3 304131

Included observations: 304128 after adjustments

Number of ordered indicator values: 4

Convergence achieved after 5 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.131878 0.001297 101.683 0

AJ(-1) 0.673158 0.004354 154.6104 0

10000*DLOG(ASK) 0.320523 0.001841 174.0656 0

Limit Points

LIMIT_2:C(4) 0.955897 0.010468 91.31565 0

LIMIT_3:C(5) 1.626336 0.010676 152.3301 0

LIMIT_4:C(6) 5.78533 0.016938 341.5674 0

Pseudo R-squared 0.102908 Akaike info criterion 1.944117

Schwarz criterion 1.944327 Log likelihood -295624.3

Hannan-Quinn criter. 1.944178 Restr. log likelihood -329536.2

LR statistic 67823.94 Avg. log likelihood -0.972039

Prob(LR statistic) 0

67

A.1.1.8 Ordered Logit Results: 10 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Logit (Quadratic hill climbing)

Sample (adjusted): 2 308749

Included observations: 307943 after adjustments

Number of ordered indicator values: 10

Convergence achieved after 7 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.155742 0.001351 115.2591 0

AJ(-1) 0.159926 0.001594 100.3382 0

Limit Points

LIMIT_2:C(3) -5.137085 0.053891 -95.32363 0

LIMIT_3:C(4) -3.762068 0.028652 -131.3013 0

LIMIT_4:C(5) -3.158783 0.022402 -141.0075 0

LIMIT_5:C(6) 0.717831 0.011771 60.98525 0

LIMIT_6:C(7) 0.729267 0.011771 61.95536 0

LIMIT_7:C(8) 1.29396 0.011879 108.9279 0

LIMIT_8:C(9) 1.339747 0.011894 112.6399 0

LIMIT_9:C(10) 1.341132 0.011895 112.7518 0

LIMIT_10:C(11) 5.194799 0.016561 313.6803 0

Pseudo R-squared 0.04758 Akaike info criterion 2.23514

Schwarz criterion 2.23552 Log likelihood -344136.9

Hannan-Quinn criter. 2.23525 Restr. log likelihood -361329

LR statistic 34384.2 Avg. log likelihood -1.117534

Prob(LR statistic) 0

68

A.1.1.9 Ordered Logit (with Returns) Results: 10 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Logit (Quadratic hill climbing)

Sample (adjusted): 2 308749

Included observations: 307943 after adjustments

Number of ordered indicator values: 10

Convergence achieved after 7 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.15917 0.001399 113.7732 0

AJ(-1) 0.253184 0.00173 146.3672 0

10000*DLOG(ASK) 0.318154 0.001836 173.2477 0

Limit Points

LIMIT_2:C(4) -4.663842 0.053994 -86.37753 0

LIMIT_3:C(5) -3.286633 0.028848 -113.9311 0

LIMIT_4:C(6) -2.681408 0.022654 -118.3644 0

LIMIT_5:C(7) 1.308867 0.012554 104.2614 0

LIMIT_6:C(8) 1.321246 0.012556 105.2298 0

LIMIT_7:C(9) 1.93451 0.012762 151.5792 0

LIMIT_8:C(10) 1.984385 0.012786 155.2056 0

LIMIT_9:C(11) 1.985893 0.012786 155.3148 0

LIMIT_10:C(12) 6.194035 0.018747 330.3986 0

Pseudo R-squared 0.093349 Akaike info criterion 2.127739

Schwarz criterion 2.128154 Log likelihood -327599.2

Hannan-Quinn criter. 2.127859 Restr. log likelihood -361329

LR statistic 67459.66 Avg. log likelihood -1.063831

Prob(LR statistic) 0

69

A.1.2 Dataset 2: USD-USD April 1989 to June 1989:

A.1.2.1 MA(1)-GARCH(1,1) Results:

Dependent Variable: 10000*DLOG(ASK)

Method: ML - ARCH

Sample (adjusted): 2 8445

Included observations: 8444 after adjustments

Convergence achieved after 37 iterations

MA Backcast: 1

Presample variance: backcast (parameter = 0.7)

GARCH = C(3) + C(4)*RESID(-1)^2 + C(5)*GARCH(-1)

Variable Coefficient Std. Error z-Statistic Prob.

C 0.045205 0.013771 3.282516 0.001

MA(1) -0.3281 0.011435 -28.693 0

Variance Equation

C 0.683349 0.025552 26.7437 0

RESID(-1)^2 0.265029 0.008055 32.9008 0

GARCH(-1) 0.653991 0.007513 87.05354 0

R-squared 0.046483 Mean dependent var 0.001809

Adjusted R-squared 0.04637 S.D. dependent var 2.611027

S.E. of regression 2.549771 Akaike info criterion 4.444882

Sum squared resid 54884.24 Schwarz criterion 4.449051

Log likelihood -18761.29 Hannan-Quinn criter. 4.446305

Durbin-Watson stat 1.819609

Inverted MA Roots 0.33

70

A.1.2.2 Ordered Probit Results: 4 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Probit (Quadratic hill climbing)

Sample (adjusted): 2 8445

Included observations: 8444 after adjustments

Number of ordered indicator values: 4

Convergence achieved after 5 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCH01 0.009127 0.000855 10.67187 0

AJ(-1) 0.942999 0.042231 22.3298 0

Limit Points

LIMIT_2:C(3) 0.61897 0.123303 5.019921 0

LIMIT_3:C(4) 1.002232 0.121611 8.241273 0

LIMIT_4:C(5) 4.898957 0.134626 36.38941 0

Pseudo R-squared 0.115395 Akaike info criterion 0.581462

Schwarz criterion 0.585632 Log likelihood -2449.933

Hannan-Quinn criter. 0.582885 Restr. log likelihood -2769.524

LR statistic 639.1806 Avg. log likelihood -0.290139

Prob(LR statistic) 0

71

A.1.2.3 Ordered Probit (with Returns) Results: 4 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Probit (Quadratic hill climbing)

Sample (adjusted): 2 8445

Included observations: 8444 after adjustments

Number of ordered indicator values: 4

Convergence achieved after 5 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.00933 0.000852 10.94538 0

AJ(-1) 1.008975 0.043056 23.43378 0

10000*DLOG(ASK) 0.08268 0.006736 12.27428 0

Limit Points

LIMIT_2:C(4) 0.775747 0.125149 6.198581 0

LIMIT_3:C(5) 1.166192 0.12345 9.446642 0

LIMIT_4:C(6) 5.148438 0.138288 37.22976 0

Pseudo R-squared 0.142475 Akaike info criterion 0.563936

Schwarz criterion 0.568939 Log likelihood -2374.936

Hannan-Quinn criter. 0.565644 Restr. log likelihood -2769.524

LR statistic 789.1746 Avg. log likelihood -0.281257

Prob(LR statistic) 0

72

A.1.2.4 Ordered Probit Results: 10 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Probit (Quadratic hill climbing)

Sample (adjusted): 2 8445

Included observations: 8444 after adjustments

Number of ordered indicator values: 10

Convergence achieved after 7 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.010588 0.000829 12.7664 0

AJ(-1) 0.293255 0.018241 16.07658 0

Limit Points

LIMIT_2:C(3) -1.046148 0.251299 -4.162967 0

LIMIT_3:C(4) -0.925167 0.225398 -4.104586 0

LIMIT_4:C(5) -0.71307 0.195539 -3.646689 0.0003

LIMIT_5:C(6) 0.463308 0.159031 2.91332 0.0036

LIMIT_6:C(7) 0.525466 0.158821 3.308537 0.0009

LIMIT_7:C(8) 0.77686 0.158252 4.908998 0

LIMIT_8:C(9) 0.837742 0.158161 5.296765 0

LIMIT_9:C(10) 0.843638 0.158153 5.334317 0

LIMIT_10:C(11) 4.644992 0.167892 27.66655 0

Pseudo R-squared 0.069425 Akaike info criterion 0.65859

Schwarz criterion 0.667763 Log likelihood -2769.568

Hannan-Quinn criter. 0.661721 Restr. log likelihood -2976.191

LR statistic 413.2452 Avg. log likelihood -0.327992

Prob(LR statistic) 0

73

A.1.2.5 Ordered Probit (with Returns) Results: 10 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Probit (Quadratic hill climbing)

Sample (adjusted): 2 8445

Included observations: 8444 after adjustments

Number of ordered indicator values: 10

Convergence achieved after 7 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.010826 0.000828 13.08258 0

AJ(-1) 0.313473 0.018435 17.00409 0

10000*DLOG(ASK) 0.074509 0.006572 11.33749 0

Limit Points

LIMIT_2:C(4) -0.920766 0.2527 -3.643716 0.0003

LIMIT_3:C(5) -0.799597 0.226892 -3.524124 0.0004

LIMIT_4:C(6) -0.586622 0.197098 -2.976292 0.0029

LIMIT_5:C(7) 0.609972 0.160333 3.804416 0.0001

LIMIT_6:C(8) 0.673407 0.160125 4.205514 0

LIMIT_7:C(9) 0.92919 0.159566 5.823252 0

LIMIT_8:C(10) 0.991005 0.159477 6.214104 0

LIMIT_9:C(11) 0.996988 0.159469 6.251929 0

LIMIT_10:C(12) 4.866967 0.170386 28.56432 0

Pseudo R-squared 0.09087 Akaike info criterion 0.64371

Schwarz criterion 0.653717 Log likelihood -2705.745

Hannan-Quinn criter. 0.647126 Restr. log likelihood -2976.191

LR statistic 540.8901 Avg. log likelihood -0.320434

Prob(LR statistic) 0

74

A.1.2.6 Ordered Logit Results: 4 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Logit (Quadratic hill climbing)

Sample (adjusted): 2 8445

Included observations: 8444 after adjustments

Number of ordered indicator values: 4

Convergence achieved after 7 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.023145 0.002506 9.234157 0

AJ(-1) 1.816022 0.078415 23.15919 0

Limit Points

LIMIT_2:C(3) 1.151811 0.221143 5.208446 0

LIMIT_3:C(4) 2.052707 0.215518 9.524505 0

LIMIT_4:C(5) 9.285628 0.252771 36.73541 0

Pseudo R-squared 0.11296 Akaike info criterion 0.583059

Schwarz criterion 0.587229 Log likelihood -2456.677

Hannan-Quinn criter. 0.584483 Restr. log likelihood -2769.524

LR statistic 625.6929 Avg. log likelihood -0.290938

Prob(LR statistic) 0

75

A.1.2.7 Ordered Logit (with Returns) Results: 4 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Logit (Quadratic hill climbing)

Sample (adjusted): 2 8445

Included observations: 8444 after adjustments

Number of ordered indicator values: 4

Convergence achieved after 8 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.023498 0.002679 8.772378 0

AJ(-1) 1.937969 0.080338 24.12276 0

10000*DLOG(ASK) 0.179594 0.014658 12.25201 0

Limit Points

LIMIT_2:C(4) 1.431605 0.224685 6.371611 0

LIMIT_3:C(5) 2.341427 0.219477 10.66822 0

LIMIT_4:C(6) 9.770045 0.261472 37.36562 0

Pseudo R-squared 0.139367 Akaike info criterion 0.565974

Schwarz criterion 0.570977 Log likelihood -2383.542

Hannan-Quinn criter. 0.567682 Restr. log likelihood -2769.524

LR statistic 771.9628 Avg. log likelihood -0.282276

Prob(LR statistic) 0

76

A.1.2.8 Ordered Logit Results: 10 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Logit (Quadratic hill climbing)

Sample (adjusted): 2 8445

Included observations: 8444 after adjustments

Number of ordered indicator values: 10

Convergence achieved after 6 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.030535 0.00282 10.82827 0

AJ(-1) 0.563651 0.033692 16.72951 0

Limit Points

LIMIT_2:C(3) -3.399721 0.756259 -4.495444 0

LIMIT_3:C(4) -2.993661 0.63663 -4.702359 0

LIMIT_4:C(5) -2.298438 0.488651 -4.703637 0

LIMIT_5:C(6) 0.926596 0.286528 3.233876 0.0012

LIMIT_6:C(7) 1.076884 0.285436 3.77277 0.0002

LIMIT_7:C(8) 1.66173 0.282811 5.875773 0

LIMIT_8:C(9) 1.797737 0.282485 6.364009 0

LIMIT_9:C(10) 1.810792 0.282458 6.41083 0

LIMIT_10:C(11) 8.845043 0.310773 28.46145 0

Pseudo R-squared 0.068507 Akaike info criterion 0.659237

Schwarz criterion 0.66841 Log likelihood -2772.3

Hannan-Quinn criter. 0.662368 Restr. log likelihood -2976.191

LR statistic 407.7821 Avg. log likelihood -0.328316

Prob(LR statistic) 0

77

A.1.2.9 Ordered Logit (with Returns) Results: 10 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Logit (Quadratic hill climbing)

Sample (adjusted): 2 8445

Included observations: 8444 after adjustments

Number of ordered indicator values: 10

Convergence achieved after 8 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.031698 0.002984 10.62409 0

AJ(-1) 0.605872 0.03419 17.72067 0

10000*DLOG(ASK) 0.167709 0.014728 11.38731 0

Limit Points

LIMIT_2:C(4) -3.108606 0.756454 -4.109446 0

LIMIT_3:C(5) -2.702375 0.63687 -4.243211 0

LIMIT_4:C(6) -2.004677 0.48917 -4.098116 0

LIMIT_5:C(7) 1.236004 0.289368 4.271391 0

LIMIT_6:C(8) 1.387414 0.288368 4.811259 0

LIMIT_7:C(9) 1.976024 0.286018 6.908731 0

LIMIT_8:C(10) 2.112879 0.285744 7.394317 0

LIMIT_9:C(11) 2.126018 0.285722 7.440867 0

LIMIT_10:C(12) 9.336144 0.318108 29.349 0

Pseudo R-squared 0.09058 Akaike info criterion 0.643914

Schwarz criterion 0.653921 Log likelihood -2706.607

Hannan-Quinn criter. 0.64733 Restr. log likelihood -2976.191

LR statistic 539.1676 Avg. log likelihood -0.320536

Prob(LR statistic) 0

78

A.1.3 Dataset 3: USD-USD April 2006 to May 2006:

A.1.3.1 MA(1)-GARCH(1,1) Results:

Dependent Variable: 10000*DLOG(ASK)

Method: ML - ARCH (Marquardt) - Normal distribution

Sample (adjusted): 2 551356

Included observations: 551355 after adjustments

Convergence achieved after 14 iterations

MA Backcast: 1

Presample variance: backcast (parameter = 0.7)

GARCH = C(3) + C(4)*RESID(-1)^2 + C(5)*GARCH(-1)

Variable Coefficient Std. Error z-Statistic Prob.

C 0.002535 0.000358 7.075531 0

MA(1) -0.781719 0.000858 -911.204 0

Variance Equation

C 0.057826 0.000813 71.15628 0

RESID(-1)^2 0.063219 0.000558 113.2785 0

GARCH(-1) 0.902484 0.000889 1015.04 0

R-squared 0.372225 Mean dependent var -0.000425

Adjusted R-squared 0.372224 S.D. dependent var 1.657286

S.E. of regression 1.313106 Akaike info criterion 3.302185

Sum squared resid 950669.3 Schwarz criterion 3.302287

Log likelihood -910333.2 Hannan-Quinn criter. 3.302214

Durbin-Watson stat 1.97678

Inverted MA Roots 0.78

79

A.1.3.2 Ordered Probit Results: 4 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Probit (Quadratic hill climbing)

Sample (adjusted): 2 551356

Included observations: 551355 after adjustments

Number of ordered indicator values: 4

Convergence achieved after 4 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.046421 0.001588 29.24124 0

AJ(-1) -0.130554 0.001879 -69.46221 0

Limit Points

LIMIT_2:C(3) -0.267391 0.004557 -58.67524 0

LIMIT_3:C(4) 0.497267 0.004577 108.652 0

LIMIT_4:C(5) 3.624999 0.036661 98.87791 0

Pseudo R-squared 0.00466 Akaike info criterion 2.122714

Schwarz criterion 2.122815 Log likelihood -585179.4

Hannan-Quinn criter. 2.122742 Restr. log likelihood -587919.3

LR statistic 5479.851 Avg. log likelihood -1.061348

Prob(LR statistic) 0

80

A.1.3.3 Ordered Probit (with Returns) Results: 4 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Probit (Quadratic hill climbing)

Sample (adjusted): 2 551356

Included observations: 551355 after adjustments

Number of ordered indicator values: 4

Convergence achieved after 6 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.032475 0.001698 19.12882 0

AJ(-1) 0.520271 0.002468 210.7702 0

10000*DLOG(ASK) 0.624067 0.001388 449.5486 0

Limit Points

LIMIT_2:C(4) 0.803072 0.005446 147.4683 0

LIMIT_3:C(5) 1.84724 0.00582 317.4066 0

LIMIT_4:C(6) 6.264271 0.051481 121.682 0

Pseudo R-squared 0.202812 Akaike info criterion 1.700133

Schwarz criterion 1.700255 Log likelihood -468682.4

Hannan-Quinn criter. 1.700167 Restr. log likelihood -587919.3

LR statistic 238473.8 Avg. log likelihood -0.850056

Prob(LR statistic) 0

81

A.1.3.4 Ordered Probit Results: 10 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Probit (Quadratic hill climbing)

Sample (adjusted): 2 551356

Included observations: 530382 after adjustments

Number of ordered indicator values: 10

Convergence achieved after 5 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.029623 0.001543 19.20169 0

AJ(-1) -0.040361 0.000655 -61.5938 0

Limit Points

LIMIT_2:C(3) -2.770052 0.008137 -340.4275 0

LIMIT_3:C(4) -2.123895 0.005776 -367.693 0

LIMIT_4:C(5) -1.541017 0.005154 -299.0033 0

LIMIT_5:C(6) -0.292156 0.004841 -60.34619 0

LIMIT_6:C(7) -0.076775 0.004831 -15.89255 0

LIMIT_7:C(8) 0.218854 0.004827 45.33503 0

LIMIT_8:C(9) 0.463249 0.00484 95.70278 0

LIMIT_9:C(10) 0.472672 0.004841 97.63469 0

LIMIT_10:C(11) 3.593189 0.037289 96.36043 0

Pseudo R-squared 0.00228 Akaike info criterion 3.351617

Schwarz criterion 3.351849 Log likelihood -888807.6

Hannan-Quinn criter. 3.351682 Restr. log likelihood -890838.9

LR statistic 4062.696 Avg. log likelihood -1.675788

Prob(LR statistic) 0

82

A.1.3.5 Ordered Probit (with Returns) Results: 10 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Probit (Quadratic hill climbing)

Sample (adjusted): 2 551356

Included observations: 530382 after adjustments

Number of ordered indicator values: 10

Failure to improve Likelihood after 17 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR -0.035043 0.001544 -22.69168 0

AJ(-1) 0.01852 0.000821 22.56212 0

10000*DLOG(ASK) 0.365238 0.001223 298.6273 0

Limit Points

LIMIT_2:C(4) -2.768453 0.008501 -325.6782 0

LIMIT_3:C(5) -2.089688 0.006173 -338.5115 0

LIMIT_4:C(6) -1.484632 0.00565 -262.7437 0

LIMIT_5:C(7) -0.148442 0.005549 -26.74997 0

LIMIT_6:C(8) 0.084178 0.005598 15.03649 0

LIMIT_7:C(9) 0.395925 0.005688 69.60886 0

LIMIT_8:C(10) 0.648621 0.005789 112.0419 0

LIMIT_9:C(11) 0.659757 0.005795 113.8488 0

LIMIT_10:C(12) 4.041679 0.025918 155.9393 0

Pseudo R-squared 0.101511 Akaike info criterion 3.018282

Schwarz criterion 3.018535 Log likelihood -800409.1

Hannan-Quinn criter. 3.018353 Restr. log likelihood -890838.9

LR statistic 180859.6 Avg. log likelihood -1.509118

Prob(LR statistic) 0

83

A.1.3.6 Ordered Logit Results: 4 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Logit (Quadratic hill climbing)

Sample (adjusted): 2 551356

Included observations: 551355 after adjustments

Number of ordered indicator values: 4

Convergence achieved after 4 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.080152 0.00277 28.93061 0

AJ(-1) -0.204018 0.003055 -66.79117 0

Limit Points

LIMIT_2:C(3) -0.41091 0.007581 -54.20336 0

LIMIT_3:C(4) 0.830244 0.007658 108.4198 0

LIMIT_4:C(5) 9.135262 0.144521 63.21045 0

Pseudo R-squared 0.004388 Akaike info criterion 2.123295

Schwarz criterion 2.123397 Log likelihood -585339.7

Hannan-Quinn criter. 2.123324 Restr. log likelihood -587919.3

LR statistic 5159.321 Avg. log likelihood -1.061638

Prob(LR statistic) 0

84

A.1.3.7 Ordered Logit (with Returns) Results: 4 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Logit (Quadratic hill climbing)

Sample (adjusted): 2 551356

Included observations: 551355 after adjustments

Number of ordered indicator values: 4

Convergence achieved after 6 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.048475 0.003264 14.85304 0

AJ(-1) 1.053246 0.004586 229.6602 0

10000*DLOG(ASK) 1.215211 0.002966 409.7483 0

Limit Points

LIMIT_2:C(4) 1.600267 0.009958 160.7016 0

LIMIT_3:C(5) 3.453473 0.011048 312.5789 0

LIMIT_4:C(6) 13.6294 0.167398 81.41909 0

Pseudo R-squared 0.216154 Akaike info criterion 1.671678

Schwarz criterion 1.671801 Log likelihood -460838.1

Hannan-Quinn criter. 1.671713 Restr. log likelihood -587919.3

LR statistic 254162.3 Avg. log likelihood -0.835828

Prob(LR statistic) 0

85

A.1.3.8 Ordered Logit Results: 10 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Logit (Quadratic hill climbing)

Sample (adjusted): 2 551356

Included observations: 530382 after adjustments

Number of ordered indicator values: 10

Convergence achieved after 5 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.059869 0.002706 22.12459 0

AJ(-1) -0.07549 0.001114 -67.78632 0

Limit Points

LIMIT_2:C(3) -5.681481 0.021378 -265.7677 0

LIMIT_3:C(4) -3.965107 0.011679 -339.4939 0

LIMIT_4:C(5) -2.690845 0.009268 -290.3316 0

LIMIT_5:C(6) -0.512979 0.008257 -62.12349 0

LIMIT_6:C(7) -0.168038 0.008229 -20.41918 0

LIMIT_7:C(8) 0.3095 0.008227 37.61812 0

LIMIT_8:C(9) 0.714603 0.008278 86.32978 0

LIMIT_9:C(10) 0.73051 0.008281 88.22038 0

LIMIT_10:C(11) 9.036028 0.147643 61.20197 0

Pseudo R-squared 0.0028 Akaike info criterion 3.34987

Schwarz criterion 3.350102 Log likelihood -888344.5

Hannan-Quinn criter. 3.349936 Restr. log likelihood -890838.9

LR statistic 4988.841 Avg. log likelihood -1.674915

Prob(LR statistic) 0

86

A.1.3.9 Ordered Logit (with Returns) Results: 10 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Logit (Quadratic hill climbing)

Sample (adjusted): 2 551356

Included observations: 530382 after adjustments

Number of ordered indicator values: 10

Convergence achieved after 6 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.067262 0.003175 21.18593 0

AJ(-1) 0.402995 0.0016 251.9007 0

10000*DLOG(ASK) 1.189108 0.002737 434.4841 0

Limit Points

LIMIT_2:C(4) -3.894364 0.022026 -176.8036 0

LIMIT_3:C(5) -2.114505 0.012808 -165.0968 0

LIMIT_4:C(6) -0.7165 0.010767 -66.54475 0

LIMIT_5:C(7) 2.04924 0.010738 190.8341 0

LIMIT_6:C(8) 2.528082 0.010914 231.6353 0

LIMIT_7:C(9) 3.225475 0.011271 286.1774 0

LIMIT_8:C(10) 3.846774 0.011692 329.0122 0

LIMIT_9:C(11) 3.872262 0.011712 330.6322 0

LIMIT_10:C(12) 13.94908 0.170499 81.81305 0

Pseudo R-squared 0.146499 Akaike info criterion 2.867156

Schwarz criterion 2.867409 Log likelihood -760331.9

Hannan-Quinn criter. 2.867227 Restr. log likelihood -890838.9

LR statistic 261014.1 Avg. log likelihood -1.433555

Prob(LR statistic) 0

87

A.1.4 Dataset 4: USD-USD April 2009 to May 2009:

A.1.4.1 MA(1)-GARCH(1,1) Results:

Dependent Variable: 10000*DLOG(ASK)

Method: ML - ARCH

Sample (adjusted): 2 1006737

Included observations: 1006736 after adjustments

Convergence achieved after 21 iterations

MA Backcast: 1

Presample variance: backcast (parameter = 0.7)

GARCH = C(3) + C(4)*RESID(-1)^2 + C(5)*GARCH(-1)

Variable Coefficient Std. Error z-Statistic Prob.

C 0.002329 0.000251 9.274136 0

MA(1) -0.78024 0.000611 -1276.001 0

Variance Equation

C 0.045284 0.000225 201.6421 0

RESID(-1)^2 0.051345 0.00021 244.0686 0

GARCH(-1) 0.919658 0.000263 3502.001 0

R-squared 0.36927 Mean dependent var -0.000386

Adjusted R-squared 0.369269 S.D. dependent var 1.602816

S.E. of regression 1.272934 Akaike info criterion 3.196957

Sum squared resid 1631271 Schwarz criterion 3.197016

Log likelihood -1609241 Hannan-Quinn criter. 3.196973

Durbin-Watson stat 1.970126

Inverted MA Roots 0.78

88

A.1.4.2 Ordered Probit Results: 4 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Probit (Quadratic hill climbing)

Sample (adjusted): 2 1006737

Included observations: 1006736 after adjustments

Number of ordered indicator values: 4

Convergence achieved after 3 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.098754 0.000867 113.8863 0

AJ(-1) 0.262245 0.00148 177.1729 0

Limit Points

LIMIT_2:C(3) 0.300383 0.003019 99.50314 0

LIMIT_3:C(4) 1.797373 0.003373 532.8891 0

LIMIT_4:C(5) 2.392075 0.003801 629.366 0

Pseudo R-squared 0.024794 Akaike info criterion 2.069774

Schwarz criterion 2.069833 Log likelihood -1041853

Hannan-Quinn criter. 2.069791 Restr. log likelihood -1068342

LR statistic 52977.45 Avg. log likelihood -1.034882

Prob(LR statistic) 0

89

A.1.4.3 Ordered Probit (with Returns) Results: 4 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Probit (Quadratic hill climbing)

Sample (adjusted): 2 1006737

Included observations: 1006736 after adjustments

Number of ordered indicator values: 4

Convergence achieved after 12 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.040619 0.000907 44.7718 0

AJ(-1) 0.260624 0.001785 146.0215 0

10000*DLOG(ASK) 0.415817 0.00095 437.6876 0

Limit Points

LIMIT_2:C(4) 0.072632 0.003441 21.10602 0

LIMIT_3:C(5) 1.741812 0.004059 429.1621 0

LIMIT_4:C(6) 2.420409 0.004675 517.7516 0

Pseudo R-squared 0.176356 Akaike info criterion 1.748103

Schwarz criterion 1.748173 Log likelihood -879933.1

Hannan-Quinn criter. 1.748122 Restr. log likelihood -1068342

LR statistic 376817.7 Avg. log likelihood -0.874046

Prob(LR statistic) 0

90

A.1.4.4 Ordered Probit Results: 10 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Probit (Quadratic hill climbing)

Sample (adjusted): 2 1006737

Included observations: 1006736 after adjustments

Number of ordered indicator values: 10

Convergence achieved after 4 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.096416 0.000823 117.0911 0

AJ(-1) 0.088372 0.000415 212.8967 0

Limit Points

LIMIT_2:C(3) -1.466867 0.003573 -410.4852 0

LIMIT_3:C(4) -0.169471 0.002717 -62.38151 0

LIMIT_4:C(5) 0.142757 0.00271 52.67088 0

LIMIT_5:C(6) 0.32063 0.002718 117.9753 0

LIMIT_6:C(7) 0.463947 0.002729 170.0266 0

LIMIT_7:C(8) 0.855945 0.002774 308.5626 0

LIMIT_8:C(9) 1.630826 0.002965 549.9868 0

LIMIT_9:C(10) 1.799457 0.003034 593.0574 0

LIMIT_10:C(11) 2.394888 0.003495 685.2099 0

Pseudo R-squared 0.016257 Akaike info criterion 4.058805

Schwarz criterion 4.058934 Log likelihood -2043062

Hannan-Quinn criter. 4.05884 Restr. log likelihood -2076824

LR statistic 67525.47 Avg. log likelihood -2.029392

Prob(LR statistic) 0

91

A.1.4.5 Ordered Probit (with Returns) Results: 10 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Probit (Quadratic hill climbing)

Sample (adjusted): 2 1006737

Included observations: 1006736 after adjustments

Number of ordered indicator values: 10

Convergence achieved after 9 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR -0.003187 0.000829 -3.843887 0.0001

AJ(-1) 0.094896 0.000502 188.9157 0

10000*DLOG(ASK) 0.399614 0.000853 468.5108 0

Limit Points

LIMIT_2:C(4) -1.889585 0.00377 -501.2568 0

LIMIT_3:C(5) -0.540899 0.002964 -182.4773 0

LIMIT_4:C(6) -0.211211 0.003013 -70.09902 0

LIMIT_5:C(7) -0.014555 0.003062 -4.753915 0

LIMIT_6:C(8) 0.153294 0.003113 49.24206 0

LIMIT_7:C(9) 0.615502 0.003255 189.0877 0

LIMIT_8:C(10) 1.481455 0.003579 413.8783 0

LIMIT_9:C(11) 1.676514 0.003697 453.4845 0

LIMIT_10:C(12) 2.40264 0.004378 548.8559 0

Pseudo R-squared 0.096012 Akaike info criterion 3.729748

Schwarz criterion 3.729889 Log likelihood -1877424

Hannan-Quinn criter. 3.729787 Restr. log likelihood -2076824

LR statistic 398801.1 Avg. log likelihood -1.864862

Prob(LR statistic) 0

92

A.1.4.6 Ordered Logit Results: 4 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Logit (Quadratic hill climbing)

Sample (adjusted): 2 1006737

Included observations: 1006736 after adjustments

Number of ordered indicator values: 4

Convergence achieved after 4 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.214626 0.001959 109.574 0

AJ(-1) 0.43948 0.002593 169.4684 0

Limit Points

LIMIT_2:C(3) 0.593662 0.00533 111.3912 0

LIMIT_3:C(4) 3.114943 0.006332 491.9238 0

LIMIT_4:C(5) 4.301442 0.007555 569.3761 0

Pseudo R-squared 0.024601 Akaike info criterion 2.070184

Schwarz criterion 2.070243 Log likelihood -1042059

Hannan-Quinn criter. 2.0702 Restr. log likelihood -1068342

LR statistic 52565.01 Avg. log likelihood -1.035087

Prob(LR statistic) 0

93

A.1.4.7 Ordered Logit (with Returns) Results: 4 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Logit (Quadratic hill climbing)

Sample (adjusted): 2 1006737

Included observations: 1006736 after adjustments

Number of ordered indicator values: 4

Convergence achieved after 5 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.222491 0.002315 96.11273 0

AJ(-1) 1.964362 0.003971 494.6543 0

10000*DLOG(ASK) 1.38648 0.002369 585.1713 0

Limit Points

LIMIT_2:C(4) 2.992082 0.007366 406.2264 0

LIMIT_3:C(5) 6.796605 0.010304 659.6204 0

LIMIT_4:C(6) 8.504201 0.012206 696.7327 0

Pseudo R-squared 0.27793 Akaike info criterion 1.532523

Schwarz criterion 1.532594 Log likelihood -771417.2

Hannan-Quinn criter. 1.532543 Restr. log likelihood -1068342

LR statistic 593849.5 Avg. log likelihood -0.766256

Prob(LR statistic) 0

94

A.1.4.8 Ordered Logit Results: 10 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Logit (Quadratic hill climbing)

Sample (adjusted): 2 1006737

Included observations: 1006736 after adjustments

Number of ordered indicator values: 10

Convergence achieved after 4 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.204722 0.001844 110.9948 0

AJ(-1) 0.149279 0.000728 205.0571 0

Limit Points

LIMIT_2:C(3) -2.795295 0.007967 -350.8518 0

LIMIT_3:C(4) -0.187268 0.004866 -38.48186 0

LIMIT_4:C(5) 0.339075 0.004839 70.07788 0

LIMIT_5:C(6) 0.630813 0.004859 129.8187 0

LIMIT_6:C(7) 0.863371 0.004891 176.5268 0

LIMIT_7:C(8) 1.496184 0.005024 297.8132 0

LIMIT_8:C(9) 2.804875 0.005538 506.4991 0

LIMIT_9:C(10) 3.112486 0.005723 543.812 0

LIMIT_10:C(11) 4.297395 0.007016 612.4985 0

Pseudo R-squared 0.01601 Akaike info criterion 4.059823

Schwarz criterion 4.059952 Log likelihood -2043574

Hannan-Quinn criter. 4.059859 Restr. log likelihood -2076824

LR statistic 66500.5 Avg. log likelihood -2.029901

Prob(LR statistic) 0

95

A.1.4.9 Ordered Logit (with Returns) Results: 10 Ordered Values

Dependent Variable: AJ

Method: ML - Ordered Logit (Quadratic hill climbing)

Sample (adjusted): 2 1006737

Included observations: 1006736 after adjustments

Number of ordered indicator values: 10

Convergence achieved after 5 iterations

Covariance matrix computed using second derivatives

Variable Coefficient Std. Error z-Statistic Prob.

GARCHVAR 0.268841 0.002158 124.5891 0

AJ(-1) 0.575528 0.001002 574.3314 0

10000*DLOG(ASK) 1.283457 0.001961 654.4871 0

Limit Points

LIMIT_2:C(4) -1.499334 0.008444 -177.5703 0

LIMIT_3:C(5) 1.549476 0.005795 267.3935 0

LIMIT_4:C(6) 2.288018 0.005979 382.6506 0

LIMIT_5:C(7) 2.734323 0.006163 443.6451 0

LIMIT_6:C(8) 3.100859 0.006343 488.8769 0

LIMIT_7:C(9) 4.034615 0.006789 594.2899 0

LIMIT_8:C(10) 5.85286 0.007889 741.9462 0

LIMIT_9:C(11) 6.285226 0.008209 765.6376 0

LIMIT_10:C(12) 7.959922 0.010167 782.9249 0

Pseudo R-squared 0.158021 Akaike info criterion 3.473909

Schwarz criterion 3.47405 Log likelihood -1748643

Hannan-Quinn criter. 3.473948 Restr. log likelihood -2076824

LR statistic 656363.1 Avg. log likelihood -1.736943

Prob(LR statistic) 0

ANALYSIS OF SINGAPORE’S FOREIGN EXCHANGE MARKET MICROSTRUCTURE

WAN CHEE WAI

SINGAPORE MANAGEMENT UNIVERSITY 2011

Analysis of Singapore’s Foreign Exchange Market Microstructure

by Wan Chee Wai

Submitted to the School of Economics in partial fulfillment of the requirements for the Degree of Master of Science in Economics

Thesis Committee:

Tse Yiu Kuen (Supervisor/Chair) Professor of Economics Singapore Management University Hoon Hian Teck Professor of Economics Singapore Management University Anthony Tay Associate Professor of Economics Singapore Management University

Singapore Management University 2011 Copyright (2011) Wan Chee Wai

Our data set comprises high-frequency USD/SGD tick data of three separate years (April-June 1989. and iii) the size of the bid-ask spreads may also be positively related to the directional movement of exchange rates. We found that for the USD/SGD: i) the size of bid-ask spreads are positively related to the underlying exchange rate volatility. .Analysis of Singapore’s Foreign Exchange Market Microstructure Wan Chee Wai Abstract This paper analyses the Singapore foreign exchange market from a microstructure approach. April-May 2009). ii) the magnitude of the dependence on underlying volatility increases as tick volume increases. by applying and modifying the empirical methodology designed by Bollerslev and Melvin (1994). April-May 2006. Specifically. we examine the relationship between bid-ask spreads and the underlying volatility of the USD/SGD.

..3 A......................................................................2 3...............1.......................................................66 Ordered Logit Results: 10 Ordered Values ..........................................68 Dataset 2: USD-USD April 1989 to June 1989: ....6 A.....................................50 Summary...............21 3 Empirical Analysis .......27 3.............60 A.............................................1..............2...10 2.....................................69 MA(1)-GARCH(1.........4 3.......................................................................7 A............................72 Ordered Probit (with Returns) Results: 10 Ordered Values............1.........8 A.........................................................................2.....................................................1.............................................................34 GARCH Analysis .......................1.67 Ordered Logit (with Returns) Results: 10 Ordered Values .............................55 References..................1.............1.....9 A......................4 A.....74 Ordered Logit (with Returns) Results: 4 Ordered Values .6 Empirical Methodology ..............................................1.........63 Ordered Probit (with Returns) Results: 10 Ordered Values.1........1.............1 2.......2...60 Ordered Probit Results: 4 Ordered Values.................2.................1............................1 1............4 A..1 3..................................................................1...1.1 1..............................................................................................53 4 Conclusion ..............................7 Dataset 1: USD-DEM April 1989 to June 1989: ....1 A.......................iv 1 Introduction..3 A..........1...................................................i Acknowledgement ..Table of Contents Table of Contents ......................73 Ordered Logit Results: 4 Ordered Values ............................5 A.......................3 3.......................................69 Ordered Probit Results: 4 Ordered Values...........................................1.1..........................................................................................44 Ordered Response Analysis ........................................................65 Ordered Logit (with Returns) Results: 4 Ordered Values ...............................9 2 Bid-Ask Spreads in Exchange Rates...................................................60 MA(1)-GARCH(1..................................1...47 Incorporating Returns ............................................. 11 Bid-Ask Spreads and Volatility................................2 A...............................................2 A....................................2................1..64 Ordered Logit Results: 4 Ordered Values ..3 The Singapore Foreign Exchange Market ............................................61 Ordered Probit (with Returns) Results: 4 Ordered Values..............................................1..........1) Results: ...............................................5 3.................1................................75 i .....................1.................................................................................................................................................................................28 Description of the Data...............................1...................................2 1.1......2......................................................18 Bollerslev & Melvin’s Model of Volatility and Bid-Ask Spread .....................1...1............................1....................................5 Organization of Thesis..2......2 The Microstructure Approach to Exchange Rate Economics ...........1...2 2.................3 Bid-Ask Spreads and Asymmetric Information.....................57 Appendix 1 – EViews Results...............................................................................................................5 A..........71 Ordered Probit Results: 10 Ordered Values........62 Ordered Probit Results: 10 Ordered Values........................................................................6 A.................................................................................1) Results: ........................70 Ordered Probit (with Returns) Results: 4 Ordered Values....................1 A.1 A........................2 A....

.................................7 A..........1.........3.....1................80 Ordered Probit Results: 10 Ordered Values..3 A.................1 A....87 MA(1)-GARCH(1.......1.....6 A...............................................3.....85 Ordered Logit (with Returns) Results: 10 Ordered Values ...........86 Dataset 4: USD-USD April 2009 to May 2009: .......6 A........................................79 Ordered Probit (with Returns) Results: 4 Ordered Values..........8 A.....1............3.....................3....1.........4.....1......2.................................78 Ordered Probit Results: 4 Ordered Values.......................95 ii .....89 Ordered Probit Results: 10 Ordered Values.83 Ordered Logit (with Returns) Results: 4 Ordered Values .............1.A...1....3 A...........................................3....1...................9 A.......1.......4....4 A...................91 Ordered Logit Results: 4 Ordered Values ............7 A...........................1....................................4..93 Ordered Logit Results: 10 Ordered Values .......1 A.........1......4 A......................4...........4.............87 Ordered Probit Results: 4 Ordered Values......1.4........1.1........................................................................88 Ordered Probit (with Returns) Results: 4 Ordered Values..................................................92 Ordered Logit (with Returns) Results: 4 Ordered Values ...3.2....1) Results: ..........................1......1................76 Ordered Logit (with Returns) Results: 10 Ordered Values ..............1.................................................2 A.......78 MA(1)-GARCH(1.3 A.1.........3................1) Results: .............................................8 A.........4 A.....1...................82 Ordered Logit Results: 4 Ordered Values .............1......5 A.....8 A............................3.....................9 Ordered Logit Results: 10 Ordered Values ..........90 Ordered Probit (with Returns) Results: 10 Ordered Values.....2 A.......4..84 Ordered Logit Results: 10 Ordered Values ...............................94 Ordered Logit (with Returns) Results: 10 Ordered Values ............4................................3...................................81 Ordered Probit (with Returns) Results: 10 Ordered Values.........................4..........9 A....................77 Dataset 3: USD-USD April 2006 to May 2006: ..............1.....................5 A........................

40 Table 12: Frequency Distribution of Spreads USD-SGD April-June 2006............51 Table 22: Ordered Logit Estimates (with Returns) for all Datasets (4 ordered values)...................................................................47 Table 19: Ordered Probit Estimates for all Datasets (10 ordered indicator values) .................................................50 Table 21: Ordered Probit Estimates (with Returns) for all Datasets (4 ordered values)....37 Table 7: Volume of Quotes of USD/SGD April-June 1989............................................................................List of Figures & Tables Figure 1: USD/SGD vs GDP & Quotes ...........32 Table 3: Quote Volume differences between B&M and Purchased Data USD/DEM 1989 ..........3 Table 1: USD/SGD April-May 2006 Spread Behavior ....................................................36 Table 5: Frequency of No Spread Change with Olsen USD/DEM 1989 .....................................49 Table 20: Ordered Logit Estimates for all Datasets (10 ordered indicator values).......35 Table 4: Frequency of No Spread Change reported by B&M USD/DEM 1989 .....................................45 Table 17: Ordered Probit Estimates for all Datasets (4 ordered indicator values) ..39 Table 11: Frequency of No Spread Change for USD-SGD April-May 2006 .................................41 Table 13: Volume of Quotes of USD/SGD April-May 2009.....................................................................8 Table 2: Distribution of Spreads of USD/DEM April-June 1989.........41 Table 14: Frequency of No Spread Change for USD-SGD April-May 2009 ............................................................................51 Table 23: Ordered Probit Estimates (with Returns) for all Datasets (10 ordered values).........................36 Table 6: Frequency Distribution of Spreads USD/DEM 1989 .....................................43 Table 16: GARCH Estimates for all Datasets .................................38 Table 9: Frequency Distribution of Spreads USD/SGD April-June 1989 ...............39 Table 10: Volume of Quotes of USD-SGD April-May 2006..................................................................47 Table 18: Ordered Logit Estimates for all Datasets (4 ordered indicator values)....52 iii .52 Table 24: Ordered Logit Estimates (with Returns) for all Datasets (10 ordered values)..........................42 Table 15: Frequency Distribution of Spreads USD-SGD April-May 2009............37 Table 8: Frequency of No Spread Change for USD/SGD April-June 1989 .........................................................

my academic life (the completion of this thesis!) had unfortunately taken a backseat. this paper would never have seen the light of day. patience. Due to challenges in my professional life (overseas posting!) and priorities in my personal life (wedding!). and steadfast encouragement to me during this time when I spent more time on this thesis than with her. Without the generous assistance of these kind professors. and for tolerating my nonsense. I would like to thank Erfei for her love. Lastly. Lilian Seah for her tireless efforts with regards to the administrative aspects of the thesis. I also like to thank Ms. guidance and advice to me with regards to the completion of this thesis. I promise this will be my last part-time academic pursuit.Acknowledgement I would like to thank Professor Tse Yiu Kuen. iv . Professor Hoon Hian Teck and Professor Anthony Tay for their patience.

The volume of USD/SGD quotes from April to June in 1989 is slightly over 8. and on over 1 million USD/SGD quotes from the same months in 2009.000 USD/SGD quotes from April to May 2006. one of the most highly-traded currency pair in 1989. performed an empirical analysis on the USD/DEM. 1 . Hence.000.1 Introduction In “Bid-Ask Spreads and Volatility in the Foreign Exchange Market – An Empirical Analysis”. and showed that the size of the bid-ask spread of is positively related to its underlying exchange rate uncertainty. Their dataset consist of more than 300. Tim Bollerslev. we want to examine whether B&M’s result is applicable to a much lesser-traded currency belonging to a much smaller developing economy with a government-managed floating exchange rate regime – the USD/SGD. an early microstructure paper in 1994. we fast-forward 17 and 20 years into the future from 1989. B&M).000 continuously recorded USD/DEM quotes over a 3 month period from April to June in 1989. In this paper. and as Singapore evolves into a developed country. and repeat the analysis on over 600. We begin with a dataset of the USD/SGD in the same 3 month period as per B&M. We also want to examine how relationship between the size of the bid-ask spreads and exchange rate volatility changes as the USD/SGD grows in volume and significance. and Michael Melvin (henceforth.

high productivity growth. 2 . and high savings rate. The various currencies are given different weights depending on the extent of trade dependence with that particular country. We also present a review of some microstructure literature in this area. we provide more background to these two underlying themes in the next two sections: 1. specifically focusing on the bid-ask spreads of the USD/SGD. But first.This paper examines the Singapore foreign exchange market from a microstructure approach. reflected rapid economic development. The trade-weighted exchange rate is allowed to fluctuate within an undisclosed policy band. which provides flexibility for the system to accommodate short-term fluctuations in the foreign exchange markets as well as some buffer in the estimation of Singapore’s equilibrium exchange rate. The composition of the basket is revised periodically to take into account changes in Singapore’ trade patterns. On a trade-weighted basis. the SGD has appreciated against the exchange rates of its major trading partners and competitors since 1981.1 The Singapore Foreign Exchange Market The Monetary Authority of Singapore operates a float regime for the Singapore dollar that is managed against a basket of currencies of the country’s major trading partners and competitors.

The following figure shows the USD/SGD, Singapore GDP, and volume of quotes over the months of April and May from 1989 to 2009.

USD/SGD vs GDP & Quotes 2.00 1.90 1.80 USD/SGD 1.70 1.60 800 1.50 1.40 1.30 1.20 1988 600 400 200 0 1993 1998 Year USD/SGD GDP Quotes 2003 2008 1800 1600 1400 1200 1000 GDP S$B / Quotes ('000s)

Figure 1: USD/SGD vs GDP & Quotes1

From 1989 to 2009, as the Singapore GDP experienced a gradual growth from SGD 61 billion in 1989 to SGD 266 billion in 2009, the USD/SGD fluctuated between 1.40 and 1.90. Interestingly though, from 2002 onwards the growth of USD/SGD quote volume for April and May experienced a sharp increase from only 33,000 quotes in 2001 to 180,000 quotes in 2002. This growth would then accelerate to 1,630,000 quotes in 2009. It is as if all of a sudden the Singapore dollar started to become more widely traded than ever before. With increasing volume, the underlying exchange rate volatility would also be expected to increase. How much effect would this have on the bid-ask spreads of the USD/SGD. We examine this using data from 1989, 2006, and 2009.

1

USD/SGD and GDP figures obtained from Singapore Department of Statistics (singstat.gov.sg); Quotes volume obtained from Olsen Financial Technologies GmbH.

3

In 2006 the global economy had recorded a fourth consecutive year of strong growth despite the drag from crude oil prices, a buildup in global electronics inventories and adjustment in the US housing market. The MAS Annual Report for 2005/2006 reported that “despite higher oil prices, rising interest rates and natural disasters, the global economy expanded at a robust pace in 2005. This growth momentum continued unabated in the first quarter of 2006. The strength of the US economy was a major factor underpinning the continued growth of the world economy last year. The US economy displayed remarkable resilience against the backdrop of hurricane Katrina and 11 successive increases in the Fed funds rate from 2.25% at the beginning of 2005 to 5% in May 2006. In the first quarter of 2006, growth picked up strongly, led by a rebound in consumer spending and business investment spending on equipment and software.”

The Singapore economy was also in a state of stability, as reported by the MAS Annual Report 2005/2006: “In the early months of 2006, some signs of easing in the domestic economy emerged with growth momentum slowing to 6.8% in Q1. However, this is not indicative of a broad-based slowdown, but rather a retraction to a more sustainable pace of growth.”

In 2009 the world found itself in the midst of the worst global financial crisis ever since the Great Depression. The MAS Annual Report 2008/2009 reported that “2008 was a tumultuous year for the global economy. While the surge in

4

commodity prices led to strong inflationary pressures in the first half of the year, the onset of the global financial crisis caused world growth to fall sharply in the later part of 2008 and into early 2009. The emergence of the Influenza A (H1N1) virus in recent months has added a new dimension of risk to the fragile global economy.”

The global financial crisis, which saw the collapse of Lehman Brothers in September 2008, caused massive economic fallout worldwide. Amidst an erosion of confidence, global trade and industrial production collapsed in the first half of 2009, resulting in a 2.4% year-on-year contraction in world GDP over the same period. During this time, the quote volume for USD/SGD (over April and May) grew to over 1.6 million quotes, suggesting the increase in volatility in the exchange rate.

1.2

The Microstructure Approach to Exchange Rate Economics

Exchange rate economics, the branch of international economics and finance which attempt to explain the foreign exchange market, is an intriguing area of research.

There are many theories of exchange rate determination, from the open economy IS-LM models that are mandatory fare for any undergraduate economics course, to more advanced models such as the Mundell-Fleming model, the

5

But foreign exchange rates can only move through a trading process in a foreign exchange market. for example). these theories have various degrees of success in forecasting long-run exchange rates. nominal rigidities and imperfect competition. From a common-sense perspective. Foreign exchange 6 . tourism. When tested against empirical evidence. new open-economy macroeconomists attempt for formalize exchange rate in the context of dynamic general equilibrium models with explicit microfoundations. and the portfolio balance model. but others transactions may not (e.sticky/flexible-price monetary models.g.g. speculation in each others’ asset markets. If the long-run exchange rate between two countries is expected to change due to some shifting fundamental value (say productivity level. this is hardly surprising. All of them however are not able to convincingly explain short-run exchange rate fluctuations. how would any macro model (even one with microfoundations) designed to determine the “new” equilibrium exchange rate be able to take into account all the possible paths taken to transit from the “old” equilibrium rate to the “new” one? Some foreign exchange transactions between the two countries might be related to shifting fundamentals (e. Macro foreign exchange models often assume that foreign exchange rates will move when fundamentals move. More recently. import/export transactions). etc).

In their 2007 paper “Exchange Rate Fundamentals and Order Flow".5 years. as the two hallmarks of the microstructure approach. “The Microstructure Approach to Exchange Rates”. they tested and established four empirical results: (1) transaction flows forecast future macro variables such as output growth. such as Martin D. and inflation. 7 . Evans and Richard K. two variables that are absent from the macro approach. (3) transaction flows (proprietary) forecast future exchange rates. money growth. Well-connected researchers. Lyons managed to obtain proprietary data on all end-user EUR/USD trades received at Citibank over 6. meaning it includes information if the transaction is a sale or a purchase. These are analogous to “Quantity” and “Price” in the dimension of exchange rates. Order flow is essentially transaction volume which is “signed”. Such data is usually hard to come by and are proprietary to banks and other high-level participants in the foreign exchange market. Richard Lyons (2001) defined “Order Flow” and “Bid-Ask Spreads”. In his book. (2) transaction flows forecast these macro variables significantly better than the exchange rate does.microstructurists study this trading process. D. and (4) the forecasted part of fundamentals is better at explaining exchange rates than standard measured fundamentals.

21% 39. In fact.53% 3.81% PRICE UP PRICE SAME PRICE DOWN Total Table 1: USD/SGD April-May 2006 Spread Behavior Out of over 600. what is intriguing is that when prices move up.000 USD/SGD quotes in April and May 2006. such as information flow.85% 39.000 quotes over two months. Bid-Ask Spreads.46% 4.60% of time when the price moved down. is much easier to obtain.35% of the time when the price moved up. being a core element of most data sets. etc.47% SPREAD DOWN 3. on the other hand. the four datasets for this paper were purchased from Olsen Financial Technologies GmbH. and 6. Though we may somewhat expect for spreads to move when prices move. SPREAD UP 32. spreads tended to 8 .60% 20. they are a ready target for testable hypotheses.73% SPREAD SAME 6.42% 32. while B&M obtained theirs by collecting every USD/DEM quote posted on the Reuters screen for the interbank foreign exchange market for three months in 1989. Lyons highlighted that one reason spreads receive so much attention is because. Table 1 below shows the distribution of over 600. the spread remained unchanged 6.52% 6. For example. But other than being easily obtainable.35% 7.05% 3. divided into nine categories of price and spread movements. This is in contrast to other features in the trading that are not so easily measurable. belief dispersion.Data for the other hallmark. The behavior of bid-ask spreads in the foreign exchange markets offers many opportunities for research.

53% of the time.21% of the time. we perform this analysis for the USD/SGD from the months of April and May in 1989. we also perform an empirical analysis on the phenomenon described above in Table 1. but yet narrowed only 3. spreads tended to narrow 32. The main currency for analysis is the USD/SGD.46% of the time. and may also differ across different time periods within the same currency. Spread behavior like in the previous example may differ across different currencies within the same time period. we use B&M’s results for the USD/DEM. For comparison against different time periods within the same currency. Chapter 4 concludes.widen 32. 1. 9 . when prices move down. and ends with a description of B&M’s model that relates volatility to bid-ask spreads. The empirical objective of this paper is thus to examine the relationship between the bid-ask spread and the underlying exchange rate volatility from such two angles. For comparison against a different currency within the same time period. and 2009.3 Organization of Thesis The rest of this paper shall be organized as follows: Chapter 2 begins with a review of microstructure papers which concerns bid-ask spreads. 2006.85% of the time but yet widened only 3. Chapter 3 describes B&M’s empirical methodology and presents the empirical analyses for each dataset. In addition. Conversely.

The third reason had to do with the history of the field of market microstructure which in its early days sought to distinguish itself from the literature on trading under rational expectations. and focus on “adverse selection” as a popular theme. Rational expectations models generally omit trading mechanisms when characterizing the relationship between fundamentals and price. Contrastingly market microstructure focused on how trading mechanisms affected prices. Lyons (2001) cites bid-ask spreads as one of the two hallmarks of the microstructure approach. He also gave two more reasons for the heavy attention and resources focused on bid-ask spreads. Besides being relatively obtainable. and this had led to “a focus on the determination of real-world transaction prices – spreads. he explained that spreads receive so much attention because they form a core element of most data sets and are a ready target for testable hypotheses. guided by Sarno & Taylor (2002). The second reason was because practitioners are “intensely concerned with managing trading costs”.2 Bid-Ask Spreads in Exchange Rates As previously mentioned in Chapter 1. we present a short survey on some early microstructure literature that concerns the determination of bid-ask spreads.” For the first section of this Chapter. We then present the views of a more contemporary paper which refutes 10 .

and the cost of adverse selection.“adverse selection” as a determinant of bid-ask spreads and proposes that asymmetric information might be a more plausible candidate. 11 . we first present a short survey on the literature which analyses the proportional relationship between spreads and exchange rate volatility. following Sarno & Taylor (2002). Cost of Dealer Services The cost of dealer services is formally analyzed by Demsetz (1968) who assumes the existence of some fixed costs of providing “predictable immediacy” as the service for which compensation is required by market makers. From the second section of this Chapter we return to our main topic of interest – bid-ask spreads and exchange rate volatility. We then close this Chapter by presenting B&M’s simple asymmetric information model which forms the framework for our empirical investigation. inventory holding costs. Similarly. 2.1 Bid-Ask Spreads and Asymmetric Information Sarno & Taylor (2002) identifies three main determinants of the bid-ask spread: the cost of dealer services. While Demsetz focused on the New York Stock Exchange. his definition for cost of dealer services could also be applicable to the foreign exchange market.

relates to the market maker's ability to make inventory adjustments when the market for an issue is "thin. and 2) high volume implies less marketability risk. The second component." They showed that volume has a negative effect on the bid-ask spread for two reasons: 1) high volume implies more competition if it implies more competition among alternative market makers. “predictable immediacy is a rarity in human actions. Amihud & Mendelson (1980) considers the problem of a price-setting monopolistic market-maker in a Garman (1976) dealership market where the 12 . which they termed “marketability risk”. and. Barnear & Logue modified the theory of the market-maker spread by distinguishing between the two major components of inventory risk. in other markets. it is the inventory markup of retailer or wholesaler”. and to approximate it requires that costs be borne by persons who specialize in standing ready and waiting to trade with the incoming orders of those who demand immediate servicing of their orders. who tested a modified theory of market-maker behavior first espoused by Bagehot (1971).According to Demsetz. therefore. The ask-bid spread is the markup that is paid for predictable immediacy of exchange in organized markets. lower positioning costs. Inventory Holding Costs The original argument of inventory costs as a crucial determinant of bid-ask spreads was first propositioned by Barnear & Logue (1975).

The focus of their analysis is the dependence of the bid-ask prices on the market-maker’s inventory position. 13 . When inventory increases both bid price and ask price decline. Ho & Stoll (1981) considers the stochastic dynamic programming problem of solving for the optimal behavior of a single dealer of a single stock who is faced with a stochastic demand for his services and return risk on his stock and on the rest of his portfolio. They derived the optimal policy the results are shown to be consistent with some conjectures and observed phenomena. The bid-ask spread is given by a risk neutral spread that maximizes expected profits for the given stochastic demand functions plus a risk premium that depends on transaction size. like the existence of a ‘preferred’ inventory position and the downward monotonicity of the bid-ask prices.stochastic demand and supply are depicted by independent Poisson processes. but the dealer’s price adjustment does. and the converse is true when inventory decreases. the dealer is able to set his bid price and ask price relative to his opinion of the "true" price of the stock so as to maximize the expected utility of terminal wealth. The bid-ask spread does not depend on the dealer's inventory position. the return variance of the stock and the dealer's attitude toward risk. They show that as time unfolds and transactions occur.

An adverse selection arises because market-makers are not able to distinguish between the two types of participants and resort to widening the spreads for both types. The origin of this argument could be traced back to Bagehot (1971). where the trading is done through economic agents who specialize in market-making for a limited set of securities. Copeland & Galai (1983) analyses the determination of bid-ask spreads in organized financial markets. Cost of Adverse Selection Adverse selection is a common argument to explain the existence of bid-ask spreads. whose model includes two types of market participants – those are willing to pay the price of the spread to the market-maker in exchange for predictable immediacy and those who can speculate at the expense of the market-maker using some private insider information.Generally. The bid-ask spread then becomes the market-maker’s defense against adverse selection in “in the form of exploitation of arbitrage opportunities”. Since Bagehot. inventory costs models assume that market-markers optimize their inventory holding. and generally imply that market-makers shift the spread downwards and increase the width of the spread when a positive inventory is accumulated. The commitment 14 . numerous microstructure papers have drawn on adverse selection as their primary interpretive framework.

and the quality of the information held by insiders. because transaction prices are informative. and the average magnitude of the spread depends on many parameters. could account for the existence of a bid-ask spread. the dealer is assumed to offer an out-of-the-money straddle option for a fixed number of shares during a fixed time interval. The exercise prices of the straddle determine the bid-ask spread. by itself. and that the bid-ask spread increases with greater price volatility in the asset being traded. Given the behavior of liquidity traders and informed traders. bid-ask spreads tend to decline with trade. The dealer establishes his profit maximizing spread by balancing the expected total revenues from liquidity trading against the expected total losses from informed trading. including the exogenous arrival patterns of insiders and liquidity traders. is analyzed as a combination of put and call options.made by dealers to buy or sell at the bid and ask prices. 15 . They showed that adverse selection. and with lower volume. the elasticity of supply and demand among liquidity traders. respectively. Glosten & Milgrom (1985) analyzed a model of a securities market in which the arrival of traders over time is accommodated by a market-maker. They also showed that. They showed that a monopolistic dealer will establish a wider bid-ask spread than will perfectly competitive dealers. with a higher asset price level.

Lyons showed that trade size and the bid-ask spreads of a particular dealer were positively related. Specifically. Mende & Menkhoff (2006) however shows evidence that the behavior of bid-ask spreads is inconsistent with adverse selection. and that customer order flow is an important source of private information.Lyons (1995) was likely one of the first who departed from early microstructure work that focused almost entirely on stock markets and applied such theory to foreign exchange markets. can 16 . He presented a model which incorporated a number of institutional features relevant to the FX market. that market net volume is only partially observable. he used one trading week’s worth of USD/DEM data derived from an electronic foreign exchange brokerage and employed the framework contained in Hasbrouck & Sofianos (1993) to test for the existence of private information effects of trading on prices. fixed operating costs. that over 80% of the trading volume is between market-makers. The first factor. His basic results confirm the existence of private information on FX markets. They outline three factors that seem likely to be important. such as the facts that major currencies are traded in decentralized dealership markets. Payne (2003) estimates a VAR decomposition of interdealer trades and quotes and interprets the results through the lens of adverse selection. indicating that adverse selection costs account for around 60% of the half-spread. Osler.

commercial customers typically know far less about market conditions than financial customers so they might be expected to pay wider spreads. even in a market with hundreds of competitors like foreign exchange. gain market power from holding information. as they do. Evans and Lyons 17 . so each individual dealer can exert a certain amount of market power despite the competition. In foreign exchange. It can be costly for customer firms to search out the best available quotes in the foreign exchange market.. (2005). but cannot explain the cross-sectional variation across customer types. As suggested in Green et al. The market power hypothesis suggests that firms. The second channel through which asymmetric information might affect bid-ask spreads in foreign exchange involves strategic dealing.g.explain the negative relation between trade size and bid-ask spreads if some costs are fixed. one involving market power and a second involving strategic dealing. and market power in quote-driven markets depends on knowledge of current market conditions. To explain why bid-ask spreads are larger for commercial than financial customers they suggest that asymmetric information – in the broad sense of information that is held by some but not all market participants – may influence spreads through two channels distinct from adverse selection. dealers may quote the widest spreads when their market power is greatest. Building on abundant evidence that customer order flow carries information (e.

the bank’s profit from providing liquidity services. When applied to two-tier markets in Naik et al. subsidizing spreads to informed customers in order to gain information which they can then exploit in upcoming interbank trades. 18 .g.g. 1982). dealers passively accept the information content of order flow. 1993). Overturf. Aliber. (1999) it implies that bid-ask spreads will be narrower for trades with information.(2007). (2002)).2 Bid-Ask Spreads and Volatility The directly proportional relationship between bid-ask spreads and exchange rate volatility now represents a fairly stylized fact in the microstructure literature. by contrast. Early studies modeled the spread as a function of transaction costs. Osler et al argue that rational foreign exchange dealers might strategically vary spreads across customers. 1975. The main conclusions of these early studies are that exchange rate spreads are wider under floating exchange rate than under fixed-exchange rate regimes (e. and that measures of exchange rate volatility are followed closely by exchange rate spreads (e. Fieleke. Daníelsson et al. In standard adverse-selection models. The idea that dealers strategically vary spreads to gather information was originally explored in Leach and Madhavan (1992. and the market-maker’s payoff for facing the exchange rate risk when assuming an open position. consistent with the pattern in foreign exchange. 2. 1975).

but also suggests that market-makers consider moments of the exchange rate higher than the second moment in order to evaluate the probability of large exchange rate changes. discretionary liquidity traders. who must trade at a precise time during the day regardless of the cost. who must trade during a day but can choose when to trade during the day in order to minimize costs. Admanti & Pfleiderer (1988) provides another fundamental theoretical contribution to this area. trading volume is explained by the concentration of trade of informed traders and discretionary liquidity traders at certain points in time: the concentrations occur because it is profitable for informed traders to trade when there are many liquidity traders who do not have the same information as themselves and because discretionary liquidity traders are attracted because the larger the number of traders lowers the cost of trading. In their model. who have relatively superior information and only trade on terms favorable to them.Glassman (1987) provides a significant contribution to this literature in that she builds a model where variables representing transactions frequency are included explicitly and the non-normality of the distribution of exchange rates is taken into account. and non-discretionary liquidity traders. The model not only provides additional evidence on the proportional relationship between exchange rate volatility and bid-ask spreads in the foreign exchange market. In this model. 19 . there are three types of agents: informed traders.

The series was also found to exhibit first-order negative serial correlation. They recorded quote arrivals and bid-ask spreads over the trading day. They also found that trading volume is time-varying. given which. Goodhart & Figliuoli (1991) reported a study of minute bid-ask quotes on three days in 1987 at a Reuters screen and found evidence that leptokurtosis and heteroscedasticity are time-varying. 20 . which is consistent with Admanti & Pfleiderer’s (1989) model. across geographical locations as well as across market participants.Bollerslev & Domowitz (1993) used intradaily data to investigate the behavior of quote arrivals and bid-ask spreads. The patterns of trading activity and spreads during the day also strongly suggest some degree of traders’ risk aversion. and are less pronounced at the minute-by-minute frequency than at lower frequencies. which is especially pronounced after immediately after jumps in the exchange rate. They found that trading activity and the bid-ask spreads for traders whose activity is restricted to regional markets can be described by a U-shaped distribution. Multivariate analysis suggested significant relationships between lagged exchange rates and the current spot rate. being higher at the European and North American openings and lower at the European lunch hour. the more trading activity is executed by informed traders. the higher the cost of trading.

3 Bollerslev & Melvin’s Model of Volatility and Bid-Ask Spread B&M is the main inspiration for this thesis. Black (1991). however greater uncertainty regarding the future spot rate. concentrated on the own statistical properties of the spread. the bid-ask spread component of transactions costs in the foreign exchange market had not received much attention in the literature. Researchers. but no one had performed any explicit analysis of the relationship between the magnitude of foreign exchange market spreads and the underlying exchange rate volatility. Melvin and Tan (1996) and Bollerslev and Domowitz (1993). Earlier studies on the subject. as both the bid and the ask prices should adjust in the same direction in response to the traders receiving buy or sell orders that reflect the particular news event. Hence. Bossaerts and Hillion (1991). had attempted to offer empirical and theoretical analyses of the determinants of foreign exchange market spreads.2. B&M opined that while unambiguous 'good' or 'bad' news regarding the fundamentals of the exchange rate should have no systematic effect on the spread. as 21 . providing most importantly a methodology to analyze the relationship between bid-ask spreads of exchange rates and its underlying volatility. B&M is likely to be the first paper to touch on this subject. such as Glassman (1987) and Boothe (1988). such as Goodhart (1990). In the early 1990’s as B&M were writing their paper.

We now outline B&M’s simple theoretical framework that illustrates this role of volatility in determining the spread. 22 . The formal setup for B&M’s stylized market microstructure model is based on the analysis in Glosten and Milgrom (1985). Information-based traders profit by intermediating the demands and supplies of foreign exchange for the liquidity traders. and Andersen (1993). information asymmetries regarding fundamentals underlying the determination of the spot exchange rate. more generally. They are also not speculators. is likely to result in a widening of the spread. Liquidity traders participate in foreign exchange transactions only due to the needs of their normal business activity which require international trade of goods. services and financial assets. These traders also take positions in the foreign exchange market based on information advantages received through their dealings with the liquidity traders or. Admati and Pfleiderer (1989). The model assumes that the foreign exchange market comprises two kinds of traders: liquidity traders and information-based traders.associated with greater volatility of the spot rate.

and Et-1(•) denotes the conditional expectation based on the information set generated by the past values of st. good for trading at time t.Bt = 2kt. are independent and symmetrically. the quoted spread for trades at time t. one of the many market-making traders will set bid and ask quotes.e. Informed traders constitute the remaining proportion of the market. and Bt = st-1 – kt.The liquidity traders constitute the proportion (1—) of the total market participants. (1) where Et-1(t)=0. Kt = At. This group of traders receives some information about the true underlying fundamental value of the exchange rate st. At = st-1 + kt.t-1. Thus. Bt and At. At time t-1. but not necessarily identically. The liquidity traders receive a signal to either buy or sell foreign currency regardless of the actual value of the currency in comparison with the bid or ask prices prevailing at the time. i. tt-1. . This fundamental value is assumed to evolve over time according to a martingale model. The bid-ask spread is assumed to be set symmetrically around the known fundamental price prevailing at the time of quote formation. Et-1(t2)= t2. B&M further assumes that the standardized innovations.t-1. distributed through time. 23 .t-1 depends on time t-1 information only.

Trader positions are limited by the convention that existing quotes are only good for up to some maximum quantity of currency. the information-based traders cannot profit from knowing the true fundamental value revealed by t. Assuming that the market-makers limit trading to one unit of currency at existing quotes. who received the signal t buy currency if At < st and sell currency if st. Since the standardized innovations. < Bt. For values of Bt ≤ st ≤ At. are assumed to be independent and symmetrically distributed through time. on average. the loss for the quoting trader relative to the true value st arising from informed trading is therefore (2) Let Pt-1(•) denote the probability conditional on the time t-1 information. for the market-maker when the opposite party an information-based trader.Trades at existing quotes will generate losses. Information-based traders. the expected loss from informed trading may be expressed as (3) 24 . The liquidity traders only know st-1 and expect t to equal zero. Zt = tt-1.

Assuming an equal probability of a buy or a sell order from the liquidity traders. (6) only depend on the time t-1 information set through t-1kt. it follows that in 25 . Kt =2kt. competition from other banks or market-makers will drive this expected profit to zero.t-1 yields (6) Since the conditional expectation and probabilities on the right-hand side of Eq. it follows that the expected profit for the quoting trader conditional on an uninformed trade equals: (4) Combining the expected trading loss in Eq. (3) with the gain in Eq. (4) yields the expected profit for the market-maker conditional on time t-1 information: In equilibrium. Expressing this zero profit condition in terms of the total spread.t-1.

B&M designed the empirical methodology that we will describe in the next chapter. the result that an increase in t2 leads to an increase in Kt would still remain generally valid.equilibrium the spread must move proportional to the conditional standard deviation of the true fundamental value of the exchange rate. Based on this relationship between exchange rate volatility and the bid-ask spread. 26 . B&M noted that while this simple proportionality condition would no longer hold true in a more general model with endogenous information acquisition.

3 Empirical Analysis B&M performed an empirical analysis on the USD/DEM. and 3) B&M’s result would hold as that economy enters into a period of worldwide financial crisis. as that country becomes a significant regional economic power in South-east Asia.000 quotes.000 continuously recorded USD/DEM quotes over a 3 month period from April to June in 1989. Before we discuss the data and empirical results. there were only slightly over 8. where over the same period from April to May 1989. 2) B&M’s result would hold 17 years later for that same currency. and when the volume of quotes increased to over 600. we first describe B&M’s empirical methodology and how we adapted it for this paper. Their dataset consist of more than 300.. For the above purposes we purchased four sets of data from Olsen Financial Technologies GmbH. 27 .000 over April and May 2006. We are curious if 1) B&M’s result would hold for the USD/SGD. The USD/DEM is a free-floating exchange rate. one of the most highly-traded currency pair between two of the largest economies in the world in 1989 and showed that the size of the bid-ask spread of the USD/DEM is positively related to its underlying exchange rate uncertainty. a semi-floating currency from a much smaller economy.

and are the parameters to be estimated. such representations have been documented by numerous studies. B&M employed a two-stage estimation procedure in which the conditional variance for the spot exchange rate is first estimated as a GARCH process. . B&M use the ask price for estimation purposes. . . They found that the MA(1)-GARCH(1. the bid and ask prices have virtually identical higher order moments and differ only very slightly in their conditional means. Step 1: Creating a Proxy for Exchange Rate Volatility The first step involves using a GARCH model as an explicit proxy for the time-varying volatility of the spot rate.1) model of the form below seemed to fit their dataset well: (7) where It-1 denotes the time t-1 information set.3.1 Empirical Methodology B&M’s empirical methodology comprises two major steps. The time t subscript refers to the place in the order 28 . and . (1992). These estimates for the conditional variance are then used as the proxy for exchange rate volatility in the second-stage model for the temporal behavior of the spread. and as noted by Bollerslev et al.

(7) may be justified by the theoretical arguments in Nelson (1990. The primary purpose of the GARCH estimation was to create proxies for the conditional variance of the exchange rate to be used in the investigation of the determinants of the spread. Intuitively. if the sample path for the true unobservable volatility process is continuous. Hence.t2 provides an estimate of the price volatility between quotes. But it was 1993 then. The particular specification for the conditional variance in Eq. They then saved all the estimates for the conditional variances from each of the 12 models and combined into a single time series of volatility estimates for the full set of weekday quotes. so that A.1) model as a non-parametric estimator. the resulting estimates for the conditional variance will generally be consistent as the length of the sampling interval goes to zero. we use modern econometrics software EViews to perform GARCH analysis on our datasets and to obtain the conditional variance time series. 1992). 29 .of the series of quotes. Today. it follows that on interpreting the GARCH(1. they divided up their dataset into 12 weeks of data and estimated each set for the above GARCH parameters. and B&M noted that estimating a GARCH model with more than 300.000 observations in practice was not feasible in practice. or a one-sided filter.

B&M used an Ordered Probit model with multiplicative heteroskedasticity for this purpose. … aJ.t. Kt. a2. The observed spread.t as a linear function of the same 30 . a1. is defined by K*t = Xi’ + K.t (9) B&M allowed for multiplicative heteroskedasticity in the spread by parameterizing the logarithm of 2K. 2K. K*.Step 2: Estimate Relationship between Spreads and Proxy for Volatility The second major step of the methodology involved using ordered response models to estimate the relationship between the time series of volatility estimates obtained in the first step and the bid-ask spreads. is assumed to take on only a fixed number of discrete values.t (8) The vector Xt denotes a set of predetermined variables that affect the conditional mean of K*t and K. The unobservable continuous random variable. is conditionally normally distributed with mean zero and variance. Specifically.

31 . a2. but the unobservable continuous random variable. K*.explanatory variables that enter the conditional mean of K*t. is similarly assumed to take on only a fixed number of discrete values. We depart from this path in our analysis. is defined by K*t = Xi’ + (10) where is i. the observed spread. Kt. standard normal for the Ordered Probit model. The ordered response models relate the observed spreads to K* via (11) where the Aj’s form an ordered partition of the real line into J disjoint intervals. and secondly by estimating the relationships with both Ordered Probit models and Ordered Logit models (to allow more flexibility in the behaviour of the error term.i. … aJ. firstly by omitting multiplicative heteroskedasticity (more due to the limitations of EViews than by choice). In our analyses. a1.d. since we omitted multiplicative heteroskedasticity). and takes the form of the logistic distribution for the Ordered Logit model.

0 percent of the total quotes. because the spreads distribution for the USD/SGD 2006 and 2009 data have more converging points (certain spread sizes where there are more quotes than others) than both the USD/DEM and the USD/SGD in 1989.2%) 7 34. In addition. < 15 329 (0. the four most commonly observed spreads account for 97.0%) 20 2. < 20 39 (0.878 (11.534 (3. Aj.856 (25.977 (1.304 (0.5%) 7 < .<5 2.2%) Note: Spreads converted into basis points Table 2: Distribution of Spreads of USD/DEM April-June 1989 We also performed the ordered response analyses with four ordered indicator values.892 (56. we used up to 10 ordered indicator values in our own 32 .0%) 10 170. < 10 2.616 (0.1%) 10 < .8%) 15 < . From the distribution of spreads of the USD/DEM in 1989. as we will see later.1%) 15 11.<7 607 (0.9%) 20 < . For tractability reasons.8%) 5 77. USD/DEM Frequency Distribution fof Spreads Spread All Quotes 0<. 572 (0. B&M based the empirical analysis on a classification of the spread into only four different categories.6%) 5<.The probability that the spread takes on the value aj is equal to the probability that K* falls into the appropriate partition.

I. The ordered response model defined above allows us to estimate the probability of a particular spread being observed as a function of the predetermined variables. the GARCH estimate of the conditional variance for the ask prices is included as one of the elements in Xt. In order to test the hypothesis that the spread is partly determined by the volatility of the spot rate. Xt. are estimated jointly with the other parameters of the model. the corresponding intervals for the unobservable latent variable K* are defined by: (12) The partition parameters. In order to take 33 .ordered response analyses. B&M noted that Bollerslev and Domowitz (1993) indicated a distinct intra-day pattern in the spread distribution and tt is possible that any significant effect of the conditional variance in isolation may merely reflect this dependence rather than provide an independent influence on the spread process. In the case of B&M where by four ordered indicator values of aj’s were used.

Dataset 3 – USD/SGD quotes from April 2006 to May 2006 d. Dataset 1 – USD/DEM quotes from April 1989 to June 1989 b. and this raises the probability of observing a higher spread. Dataset 4 – USD/SGD quotes from April 2009 to May 2009 Dataset 1: USD/DEM from April 1989 to June 1989 For the first dataset we purchased the same dataset used by B&M – USD-DEM quotes from April 1989 to June 1989. we will infer that the hypothesized theoretical link is supported by the empirical analysis.account of this own temporal dependence. We now describe each of the datasets in more details in the following section: 3. We wanted to repeat the empirical analysis 34 .t2 + 2Kt-1 + (13) Given the partition boundaries determined by the data.2 Description of the Data We purchased four sets of data from Olsen Financial Technologies GmbH: a. is caused by a larger conditional variance of the spot rate. if a higher conditional mean 'X. Dataset 2 – USD/SGD quotes from April 1989 to June 1989 c. Kt-1 was included as an element of the Xt vector in the estimation of the ordered response functions for K*t: Kt* = 1A.

Second.03% Grand Total 305. Volume of Quotes ORIGINAL BOLLERSLEV & MELVIN DAY TICKS Sun 887 0.on the dataset again to allow for an apples-to-apples comparison between the USD/DEM 1989 and the USD/SGD 1998 results.604 ticks of USD/DEM quotes while the dataset purchased from Olsen Financial Technologies GmbH contains 310. we found some minor differences.00% Table 3: Quote Volume differences between B&M and Purchased Data USD/DEM 1989 B&M collected 305.26% Sat 33 0. B&M’s results were obtained in 1993 using probably not so technologically advanced means.51% Mon 56.37% Sat 98 0. we departed from B&M’s ordered probit procedure by omitting multiplicative heteroskedasticity. The differences between our purchased data and the actual data used by B&M are tabulated as follows: a. B&M’s data were obtained from Reuters. We wanted to repeat the estimation processes again using EViews.634 21.29% Mon 60. Furthermore.109 21.00% PURCHASED FROM OLSENDATA DAY TICKS Sun 1.13% Fri 53.377 19.01% Grand Total 310. or how they presented 12 workweeks of data from an actual 13 weeks in April to June 1989. as mentioned in the previous Chapter.25% Tue 67.38% Thu 61.325 21.646 18.812 20. We obtained ours by purchasing from Olsen Financial Technologies GmbH and upon comparison. From their paper we were unable to ascertain the accuracy of this data.571 0.186 100.66% Tue 66.186 ticks.095 19.79% Fri 56.80% Wed 66.521 20.600 18. The distribution of the quotes over each workday is similar in terms of percentage in both datasets. First.604 100.88% Thu 61. 35 .63% Wed 63.082 17.

47% 52. however.83% of all ticks observed no change in spreads when the price rose and fell respectively.77% 27.76% 32.79% 32.78% 4.24% 27.619 8.b.70% 4. Frequency of No Spread Change USD/DEM No.30% Table 4: Frequency of No Spread Change reported by B&M USD/DEM 1989 B&M reported that 8% of all the quotes observed no change in spread when the bid-ask price rose and that 8.79% 10. It was not clear.23% 32.88% DIVIDED BY TOTAL NO. & Frequency of No Spread Change No Change in Spread Number Bid-Ask Rise Bid-Ask Fall All quotes 304. whether these percentages where calculated based on Number of Ticks with No Spread Change divided by Number of Ticks Moved.83% 20.38% 7.81% 59.23% 32. SPREAD UP 64384 13083 24045 101512 NO.88% PRICE UP PRICE SAME PRICE DOWN GRAND TOTAL Table 5: Frequency of No Spread Change with Olsen USD/DEM 1989 Among all ticks.90% 34. or on Number of Ticks with No Spread Change divided by Total Number of Ticks. 36 .63% and 10.70% 20.3% of all the quotes observed no change in spread when the bid-ask price fell.63% 7. We make this distinction clearer with the purchased data.65% 19. OF TICKS SPREAD SPREAD SPREAD UP SAME DOWN 20.24% 12.00% 8.86% 10.11% 19.48% 19. we counted that 10. of Quotes.90% 34. OF QUOTES SPREAD SAME 32787 39422 33407 105616 SPREAD DOWN 23767 13523 64164 101454 PRICE UP PRICE SAME PRICE DOWN Grand Total PRICE UP PRICE SAME PRICE DOWN GRAND TOTAL DIVIDED BY NO OF TICKS MOVED SPREAD SPREAD SPREAD UP SAME DOWN 53.

0%) 10 170.547 (0.00% Table 7: Volume of Quotes of USD/SGD April-June 1989 Compared against a major currency in 1989 over the same period from April to June.<5 2.43% 23. 37 .534 (3.682 (11.264 (55. The most common bid-ask spread is 10 basis points.652 1.1%) 10.000 for the USD/DEM. < 10 2.1%) 10 < .8%) 15 < .977 (1.8%) 81. a.2%) Table 6: Frequency Distribution of Spreads USD/DEM 1989 It appears that the frequency distribution of spreads is quite similar between the dataset reported by B&M and the dataset purchased from Olsen Financial Technologies GmbH.c. Frequency Distribution of Spreads Frequency Distribution of Spreads ORIGINAL Spread 0<.5%) 7 < .472 0.72% 0.14% 19.89% 22. Distribution of the quotes over the week are however quite similar.368 (26.472 USD/SGD quotes compared to over 310.5%) 327 (0. < 15 329 (0.307 2.4%) 38 (0.07% 15.586 21 8.878 (11.876 1.4%) 660 (0.0%) 171.2%) 35. < 20 39 (0.1%) 15 11. Volume of Quotes DAY Sun Mon Tue Wed Thu Fri Sat Grand Total USD/SGD 6 1. 572 (0.<7 607 (0.2%) Note: Spreads converted into basis points OLSENDATA 2.616 (0.50% 18.6%) 3.562 (0. Dataset 2: USD/SGD from April 1989 to June 1989 The second dataset are USD/SGD quotes from April 1989 to June 1989.389 (3.192 (1.6%) 5<.8%) 5 77.9%) 20 < .892 (56.856 (25.024 1.0%) 2.8%) 553 (0.2%) 7 34. there are only 8.25% 100. followed by 5 basis points.0%) 20 2.304 (0.

80% 3.02% PRICE UP PRICE SAME PRICE DOWN GRAND TOTAL Table 8: Frequency of No Spread Change for USD/SGD April-June 1989 38 . the spread remained unchanged 89. OF TICKS SPREAD SPREAD SPREAD UP SAME DOWN 1. we do not observe as much spread changes in the USD/SGD when prices moves.03% 36.50% 89.06% 4.23% 91.85% 4.73% 15. PRICE UP PRICE SAME PRICE DOWN Grand Total SPREAD UP 87 62 256 405 NO.18% 5.62% of the time.21% 8.87% 0. OF QUOTES SPREAD SAME 3108 1340 3168 7616 SPREAD DOWN 289 63 72 424 PRICE UP PRICE SAME PRICE DOWN GRAND TOTAL DIVIDED BY NO OF TICKS MOVED SPREAD SPREAD SPREAD UP SAME DOWN 2.75% 3.80% 90. When prices move downwards.51% 0. When prices move upwards.02% DIVIDED BY TOTAL NO.30% 7.03% 37.21% of the time.18% 5.47% 4.30% 4. the spread remained unchanged 90. b.80% 90.with volume peaking during midweek.42% 0.62% 2.32% 90. Frequency of No Spread Change Compared against the USD/DEM in 1989 over the same period from April to June.

0%) 10 < .32% 14.c.63% 17. they are most likely to be 5. Frequency Distribution of Spreads Frequency Distribution of Spreads USD/SGD Spread 0<.9%) 15 < .6%) 5<.2%) Note: Spreads converted into basis points Table 9: Frequency Distribution of Spreads USD/SGD April-June 1989 While spread changes in the USD/SGD are uncommon when prices moves. When spreads do change. < 10 43 (0.1%) 5 137 (1.00% Table 10: Volume of Quotes of USD-SGD April-May 2006 15 years later.96% 24. Volume of Quotes DAY Sun Mon Tue Wed Thu Fri Sat Grand Total USD/SGD 3. 7 or 20 basis points. a.037 87.400 ticks in 39 .854 (93.24% 20. Dataset 3: USD/SGD from April 2006 to May 2006 The third dataset are USD/SGD quotes from April 2006 to May 2006.31% 22. 14 (0.3%) 7 122 (1.4%) 7 < . < 15 6 (0.332 555 604. we note similar characteristics to the USD/DEM in that the most common bid-ask spread is 10 basis points. < 20 1 (0.09% 100.0%) 20 164 (1. Compared against itself in 1989 over the period from April to May. the USD/SGD has grown to become a major currency in Southeast Asia.9%) 20 < .327 126.<5 6 (0.<7 22 (0.5%) 10 7.812 147.1%) 15 76 (0.979 0. the volume of quotes of the USD/SGD has grown from over 8.44% 0.832 104.084 135.

Frequency of No Spread Change In 2006. the spread remained unchanged only 15.99% of the time compared to 89.53% 4. OF QUOTES SPREAD SAME 38121 45185 39611 122917 SPREAD DOWN 21197 20568 197313 239078 PRICE UP PRICE SAME PRICE DOWN GRAND TOTAL DIVIDED BY NO OF TICKS MOVED SPREAD SPREAD SPREAD UP SAME DOWN 76.000 ticks in 2 months.62% of the time in 1989. PRICE UP PRICE SAME PRICE DOWN Grand Total SPREAD UP 194955 24340 19302 238597 NO. The distribution of quotations over the week remains consistent with volume peaking during midweek. Now.73% 20.83% 7.52% 3.73% 20.42% 3.47% 39.53% 15.21% 6.15% 22.02% 50. when prices move upwards.85% 39.46% of the time compared to 90.67% 14.60% 32. OF TICKS SPREAD SPREAD SPREAD UP SAME DOWN 32. we observed that the tendency for spreads to remain unchanged when prices move is reduced dramatically.01% 39. the spread remained unchanged only 14.47% 39.81% DIVIDED BY TOTAL NO.05% 7.46% 6.99% 8. b. When prices move downwards.46% 77.21% of the time in 1989.3 months to over 604.81% PRICE UP PRICE SAME PRICE DOWN GRAND TOTAL Table 11: Frequency of No Spread Change for USD-SGD April-May 2006 40 .35% 3.34% 27.

377 (11.0%) 20 1 (0. a.<5 51.c.0%) 20 < .466 (25. Most of the spreads recorded are either 10 basis points or lower.9%) 10 155.634 0.090 (8.02% 20. Frequency Distribution of Spreads Frequency Distribution of Spreads USD/SGD Spread 0<. as compared to the same period in 2006.7%) 10 < .055 217.08% 22. < 10 53.00% 100.00% Table 13: Volume of Quotes of USD/SGD April-May 2009 In the year of the 2009 economic crisis.0%) 15 < . 0 (0.0%) 15 17 (0.5%) 5 224.87% 17.075.508 237.2%) 5<.3%) 7 < .0%) Note: Spreads converted into basis points Table 12: Frequency Distribution of Spreads USD-SGD April-June 2006 The characteristics of the frequency distribution of spreads have also changed almost completely over 15 years.09% 17. we observed a dramatic increase in volume of USD-SGD quotes over the period of April to May 2009. Dataset 4: USD/SGD from April 2009 to May 2009 The fourth dataset are USD/SGD quotes from April 2009 to May 2009. The most common spread in 2006 is 5 basis points.336 183. < 15 25 (0.603 32 1. followed by 10 basis points. although we noted earlier that the volume growth 41 .<7 51.604 190. Volume of Quotes DAY Sun Mon Tue Wed Thu Fri Sat Grand Total USD/SGD 9. < 20 15 (0.22% 22.496 237.163 (8.763 (37. while quotes with spreads of more than 10 basis points make up less than 0.72% 0.5%) 7 68.582 (8.01% of the entire spectrum of quotes.

74% 45. the spread remained unchanged 9. the tendency for spreads to remain unchanged when prices moved is reduced again compared to 2006.76% 64. to exceeding 1 million quotes over a 2 month period.04% 11. PRICE UP PRICE SAME PRICE DOWN Grand Total SPREAD UP 304279 59290 120972 484541 NO.17% 25.54% 4.23% 27.35% 5.21% 13.46% of the time in 2006.35% 4.76% 41.51% 11.99% of the time in 1989.44% 10. OF TICKS SPREAD SPREAD SPREAD UP SAME DOWN 28. the spread remained unchanged 10.04% 45.43% 44. Now. When prices move downwards.69% 5.28% 10. Frequency of No Spread Change We now observed that in 2009.55% 45. The volume of quotes of the USD-SGD has grown from over 604.44% 10.20% 9. b.43% 44.had been exponential since 2002.000 ticks.17% of the time compared to 14.13% PRICE UP PRICE SAME PRICE DOWN GRAND TOTAL Table 14: Frequency of No Spread Change for USD-SGD April-May 2009 42 . OF QUOTES SPREAD SAME 48129 18050 45055 111234 SPREAD DOWN 120968 53790 295733 470491 PRICE UP PRICE SAME PRICE DOWN GRAND TOTAL DIVIDED BY NO OF TICKS MOVED SPREAD SPREAD SPREAD UP SAME DOWN 64. when prices move upwards.02% 26.13% DIVIDED BY TOTAL NO.56% 1.76% of the time compared to 15.

First.5 basis points respectively.00 6.00 2. < 3.441 (8.7%) 9.903 (0.00 13.8%) 3 54.5 114.00 10. < 4.354 (5.4%) 7.432 (5.0%) 8.1%) 9 39.00 < . followed by 7 basis points and 3. < 5. < 8.2%) 4.3%) 5 59.3%) 2.c.907 (10.00 2.484 (0.00 < .1%) 11 11. < 11.00 38.2 20.0%) 2 13. < 7. followed by 10 basis points. This could indicate advancement in the market’s ability to evaluate foreign exchange risk.932 (0. the most common spreads are no longer “significant” numbers such as 5 or 10.2%) 8 268.828 (15. < 9.572 (5. Frequency Distribution of Spreads Frequency Distribution of Spreads USD/SGD Spread <2.00 579 (0. < 10.1%) 3.9%) 3. Most of the spreads recorded are still either 10 basis points or lower.00 830 (0.6%) 3.0%) 4 88.1%) > 11.613 (8.577 (25.407 (1. The most common spread in 2006 was 5 basis points.1%) 10 91.00 < .7%) 3.20 < .50 6. but quotations with spreads of more than 10 basis points have increased to slightly under 5% of the entire spectrum of quotations.00 1.080 (0.3%) 7 165.789 (3.50 < .00 8.1%) 6.5%) 5.00 < .00 < .304 (1. 43 . Two observations are of noteworthy regarding the 2009 dataset.00 < .00 < .748 (1.00 13 (0.6%) Note: Spreads converted into basis points Table 15: Frequency Distribution of Spreads USD-SGD April-May 2009 The characteristics of the frequency distribution of spreads have changed again over 3 years. < 6.158 (0.696 (3.684 (1. In 2009.00 < . < 3.6%) 6 54.422 (0.5%) 10.882 (1. the most common spread had risen to 8 basis points.

and hence being able to price bids and asks more accurately.1) model: (7) where It-1 denotes the time t-1 information set. Both phenomena could warrant future research. . We then used EViews to estimate the parameters for each dataset and the full results are attached in 44 . .1 that. .t2 provides an estimate of the price volatility between quotes. Following B&M. and are the parameters to be estimated. so that A. Second. following B&M. the volume of quotes with spreads of more than 10 basis points increased from 0. we first removed all weekend quotes.01% in 2006 to slightly under 5% in 2009. 3. Recall from Section 3.3 GARCH Analysis The primary purpose of the GARCH estimation was to create proxies for the conditional variance of the exchange rate to be used in the investigation of the determinants of the spread. we estimate for each dataset with the following MA(1)-GARCH(1. The time t subscript refers to the place in the order of the series of quotes. and . This could be attributed to the increased amount of uncertainty in the financial markets during that period of global economic crisis.

0003) 0.5953 (0. and USD/SGD 2009 data respectively.9190 0.748 8.0013) SGD1989 0. USD/SGD 2006.0018) 0.3281 (0.0561 (0.006.9888 0.0652 (0.0005) 0. Here we present a summary of the results: B&M DEM1989 0. USD/SGD 1989.0500 (0.0003) 0.0003) 0. though standard errors are significantly lower.0075) 0.0632 (0.0006) 0.0014) -0.0081) 0.5867 (0.0453 (0.9057 (0.9197 (0.7802 (0.0452 (0.0114) -0.0053) 0.0025 (0.0003) -0.0023 (0.0006) 0.0513 (0. 45 .1008 (0.0008) 0.0138) SGD2006 0.6833 (0.0052) -0. First we observe that the EViews estimates for the purchased USD/DEM dataset compares very well with B&M’s original results.Appendix 1.736 304.444 Asymptotic errors are reported in parenthesis Table 16: GARCH Estimates for all Datasets The first column contains the average of the weekly estimates from the original B&M dataset (they only estimated these parameters per workweek.355 0.7817 (0.0009) 0.2650 (0.0578 (0.0069 (0.0256) 0.0042) DEM1989 0. This provides confidence that the EViews results for the rest of the datasets are appropriate for comparison.0065 (0.0030) 0. for 12 weeks).9327 (0.0004) SGD2009 0.9025 (0.0002) 0.0002) 0.608 308.9657 551.9710 1.6540 (0.0009) -0.9708 0. The second to fifth columns contain the EViews GARCH estimates for the parameters for the purchased USD/DEM 1989.

” The GARCH effects for all datasets are all highly significant. the spread did not change 90. As the Singapore economy grows and the USD/SGD becomes a significant regional currency. The primary purpose of the GARCH estimation was to create proxies for the conditional variance of the exchange rate to be used in the investigation of the determinants of the spread. it is clear that the USD/DEM dataset shows much stronger effects. Comparing GARCH effects between the USD/DEM 1989 dataset and USD/SGD 1989 dataset. and stronger + volatility persistence. we used EViews to obtain GARCH variance series for each dataset. To this end. see Lo and MacKinlay (1990) for a formal analysis. This is expected.18% of the time. which corresponds to B&M’s results. 46 .The second observation is that all estimates for are negative. and they noted that “the negative estimates for may be partly attributed to a non-synchronous quoting phenomenon. the results show that the GARCH effects and persistence of volatility is consistent with this phenomenon. as the USD/DEM dataset contains at least 36 times more observations and from Table 8.

2040 -(66.2412) SGD2009 0.4684) 308.7912) 0.0422 (22.1299 (102.748 8.1729) 308.1592) -0.6436) SGD1989 0.736 Table 17: Ordered Probit Estimates for all Datasets (4 ordered indicator values) DEM1989 0.4622) 0.355 Z-statistics are reported in parenthesis 1.0231 (9.3298) -0.5740) 0.0091 (10. but a summary is presented below: DEM1989 0.4395 (169.2146 (109.9306) SGD2009 0.2955) 1.006.8160 (23.9604) SGD1989 0.t2 + 2Kt-1 + (13) We first use four ordered indicator values and B&M’s definitions for aj’s: a1: <= 5 a2: 5 < .4 Ordered Response Analysis Recall from Section 3.0464 (29.6719) SGD2006 0.1 that we estimate for each dataset with the following ordered response model (probit and logit): Kt* = 1A.8863) 0. < 10 a3: = 10 a4: > 10 The results for the above parameters for all four datasets are attached in Appendix 1.355 Z-statistics are reported in parenthesis 1.4330 (108.1306 -(69.3116 (135.2622 (177.444 551.0988 (113.748 8.444 551.736 Table 18: Ordered Logit Estimates for all Datasets (4 ordered indicator values) 47 .2342) SGD2006 0.0214 (73.3568) 0.0802 (28.006.3.

It is interesting to note the negative 2 values for the USD/SGD 2006 dataset. The conditional mean of Kt* is an increasing function of A.t2. The magnitude of 1 for each dataset supports what we intuitively already know. After all. 48 . coincidentally matching the growth in quote volume. The estimates for 2 are indicative of intra-day persistence in the spread process. the magnitude of the 1 values almost quadrupled. as noted above. the 2 values show that the dependence on the previous spread appears to be more significant for the USD/SGD than for the USD/DEM. although both 1 values are statistically significant. For the same reason. volatility appears to play a much larger role in determining the size of the spread for the USD/DEM. This is consistent with the implications drawn from B&M’s theoretical model. but it might be due to seasonality.18% of the time for the USD/SGD in 1989.The positive 1 coefficients for both ordered probit and logit analyses above suggest that there is a significantly positive effect of exchange rate volatility on the spread for all datasets. the spread remained the same 90. As the country grow in economic significance and the SGD becoming a major regional currency over 17 years. Comparing the USD/DEM and USD/SGD in 1989.

< 4 a5: 6 <= .5758) 0.0296 (19.2933 (16.0911) 0. < 7 a8: 9 <= . The much higher 1 values for this dataset. < 8 a9: = 10 Again. together with the larger distribution of spreads as shown in Table 15. We repeated the ordered response analyses using 10 ordered indicator values.0404 -(61.0345 (90.1124 (122. we observed a higher level of volatility in the USD/SGD.748 8. < 9 a10: > 10 a2: 3 <= .444 551.0964 (117.006. but a summary is presented below: DEM1989 0.1741) SGD1989 0. due to the larger distribution of spreads as seen in the 2006 and 2009 data. < 10 a3: 4 <= . the results for the above parameters for all four datasets are attached in Appendix 1.7664) SGD2006 0. supports the theory that the bid-ask spreads of foreign exchange rates is very much positively related to the underlying volatility. The aj’s are: a1 : < 3 a4: 5 <= . < 5 a6: 7 <= .2017) SGD2009 0.0884 (212.8967) 308.0766) -0. < 6 a7: 8 <= .5938) 0.In 2009.355 Z-statistics are reported in parenthesis 1. in midst of the worldwide financial crisis.736 Table 19: Ordered Probit Estimates for all Datasets (10 ordered indicator values) 49 .0106 (12.

the conclusions from the previous ordered response analyses with 4 ordered indicator values still holds after we attempt to be more discerning with the ordered indicator values.444 551.7295) -0.1246) SGD2009 0. and the bid-ask spreads change.5637 (16.1) model into the ordered response model: 50 .1599 (100.DEM1989 0.0305 (10.2047 (110. Previously we were examining the relationship between bid-ask spreads and the underlying volatility of exchange rates and found that positive relationships generally exists between the two.0571) 308. 11 and 14) an interesting phenomenon regarding the behavior of bid-ask spreads of foreign exchange rates.1493 (205. To examine this we repeat the ordered response analyses by including the Returns variable from the MA(1)-GARCH(1. and the bid-ask spreads change.9948) 0. they tend to narrow.1557 (115.006.7863) 0. when prices move down. Conversely.2591) SGD1989 0.748 8. We are now curious if there is any relationship between bid-ask spreads and price movement.0599 (22.3382) 0.355 Z-statistics are reported in parenthesis 1. they tend to widen.8283) SGD2006 0.5 Incorporating Returns Recall that we noted (see Tables 5. 3.736 Table 20: Ordered Logit Estimates for all Datasets (10 ordered indicator values) Generally.0755 -(67. When prices move up.

0656) 0.6104) 1.2662) 1.8530) SGD2009 0.0148 (51.736 Table 21: Ordered Probit Estimates (with Returns) for all Datasets (4 ordered values) DEM1989 0.6241 (449.3205 (174.9380 (24.7718) 0.0325 (19.0090 (23.9454) SGD2006 0.0485 (14.3865 (585.000*logAt + (14) We repeated the ordered probit and ordered logit analyses for all four datesets using both 4 and 10 ordered indicator values.7702) 0.444 551.0970 (98.0215) 0.355 Z-statistics are reported in parenthesis 1.736 Table 22: Ordered Logit Estimates (with Returns) for all Datasets (4 ordered values) 51 .1713) 308.355 Z-statistics are reported in parenthesis 1.2520) 1.0406 (44.6543) 0.9644 (494.0235 (8.6732 (154.1796 (12.5203 (210.Kt* = 1A.1127) 0.006.t2 + 2Kt-1 + 310.0093 (10.0383 (16.006.7724) SGD2006 0.748 8.5486) 0.2606 (146.444 551.1288) SGD2009 0.1319 (101.6830) SGD1989 0.4158 (437.2225 (96.2152 (409.748 8.0532 (229.0827 (12.7483) 1.4338) 0.1228) 1.3419) 0. The results are attached in Appendix 1.2743) 0.6876) 308.6602) 1.4649) SGD1989 0. but we summarize the results below: DEM1989 0.

0745 (11.0032 -(3.1592 (113.736 Table 23: Ordered Probit Estimates (with Returns) for all Datasets (10 ordered values) DEM1989 0.0108 (13.3314) 0.2835 (654.2532 (146.3182 (173.1859) SGD2009 0.006.4030 (251.0350 -(22.736 Table 24: Ordered Logit Estimates (with Returns) for all Datasets (10 ordered values) In general (except for Ordered Probit estimates for 10 ordered values).355 1.6917) SGD2009 -0.0949 (188.6241) SGD2006 0.5108) 308.DEM1989 0. the results for 1 and 2 values are consistent with the results in the previous section.6836) 0.5016) 0.444 551.5891) 0.0252) SGD1989 0. 52 .1677 (11.006. Even when taking Returns into account.3375) 0.3996 (468.0205 (54.748 8. B&M’s theory still holds.9007) 0.9157) 0.8439) 0.7207) 0.748 8.2688 (124.5621) 0.0185 (22.0673 (21.0041) 0.0042 (4.4871) 308.0317 (10.6273) 0. The results for 3 values show that a significant positive relationship also exists between the size of the bid-ask spread and the direction of the exchange rate movement.0961 (105.3135 (17.6059 (17.5755 (574.4841) 1.7732) SGD1989 0.3672) 0.0826) SGD2006 -0.355 Z-statistics are reported in parenthesis 1.0012 (298.444 551.2477) 0.3873) 1.1891 (434.

One interesting result to note are the negative 1 and 2 values for the ordered probit analyses of 2006 and 2009 for 10 ordered indicator values (see Table 23). The USD/DEM was obviously one of the most traded currency pair during that time. Not only does this violate B&M’s prediction.d.6 Summary B&M provided the theoretical framework and showed empirical evidence that the size of the bid-ask spread of exchange rates is positively related to the exchange rate’s underlying volatility. One possible explanation for this is that multiplicative heteroskedasticity.000 USD/DEM quotes from April to June of 1989. 53 . Also since we know that the error term of equations 13 and 14 are not i. 3. the results for the ordered logit analyses are probably more meaningful. Their empirical subject was over 300.d. which our ordered response models omitted but has been shown to be significant by B&M. standard normal. and both the USD and DEM belonged to floating exchange rates regimes of two of the top three largest world economies in 1989. is likely to be the cause of this results. the observation that the 1 values appear to decrease with increasing tick volume runs counter to the rest of the ordered response results.

We found that the relationship between bid-ask spreads and price direction is positive and significant. We found that B&M’s theory was still supported by the evidence. and the bid-ask spreads change. we repeated the analysis on the USD/SGD 17 years later in 2006 when the world economy was at a point of stability. Along the way we also noted the interesting phenomenon regarding the behavior of bid-ask spreads of foreign exchange rates. Furthermore. We applied a modified version of B&M’s methodology on the USD/SGD from the same months of April to June 1989 and found that the evidence (as documented in the previous section) supported their theory.We then wanted to see if both theory and empirical results would hold for a much lesser traded subject currency. when prices move down. if the currency belonged to a small country and from a semi-floating exchange rate regime – the USD/SGD. and the bid-ask spreads change. they tend to widen. they tend to narrow. We repeated the analyses on the datasets and included Returns as additional variable in the ordered response models. and again in 2009 when the world economy was somewhat in disarray. 54 . Conversely. When prices move up.

and also 55 . We departed from B&M’s methodology by omitting multiplicative heteroskedasticity. and that future work in this area using the same methodologies should include multiplicative heteroskedasticity. We provided a simple survey on microstructure literature. Future work in this area should attempt to build a model which links bid-ask spreads not only to volatility and also returns. We also noted the interesting phenomenon regarding the behavior of bid-ask spreads of foreign exchange rates. The generally “better-behaving” results from the Logit models suggests that the disturbances are indeed not standard normal. and we found that the effects of the tested parameters grew in strength as that currency grew in economic significance in its region. The results generally hold. but we tested our data using both Ordered Probit and Ordered Logit models. We included returns as additional variable in the ordered response models and found that the relationship between bid-ask spreads and price direction is positive and significant. We first touched on those which analyses bid-ask spreads and asymmetric information.4 Conclusion This paper has set out to empirically test B&M’s theory against a lesser-traded currency from a developing country with a managed floating rate regime.

presented snapshots of research involving bid-ask spreads and volatility. 56 . one of two “hallmarks” of the microstructure approach. remain a popular theme for research today. Bid-ask spreads.

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1623 192.078464 1313837 -623880. 60 .934608 0.0911 Prob.586985 Variance Equation C RESID(-1)^2 GARCH(-1) R-squared Adjusted R-squared S.6 1.518723 -455.379553 4. 0 0 Mean dependent var S.00129 z-Statistic 6.ARCH (Marquardt) .237055 0.001186 0.59 0.7) GARCH = C(3) + C(4)*RESID(-1)^2 + C(5)*GARCH(-1) Variable C MA(1) Coefficient 0.00029 0. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter.000523 0.102807 Std.773 3358.1 Dataset 1: USD-DEM April 1989 to June 1989: MA(1)-GARCH(1.942352 0.237053 2.E.102931 4.1.Appendix 1 – EViews Results A.1.D.102756 4.000278 87.007732 -0.04555 0. of regression Sum squared resid Log likelihood Durbin-Watson stat Inverted MA Roots 0.00087 2.1.51 0 0 0 0.055817 0.Normal distribution Sample (adjusted): 2 304131 Included observations: 304130 after adjustments Convergence achieved after 86 iterations MA Backcast: 1 Presample variance: backcast (parameter = 0.1) Results: Dependent Variable: 10000*DLOG(ASK) Method: ML . Error 0.1 A.

041442 2. 0 0 Akaike info criterion Log likelihood Restr.557843 2.96036 135.1 -1. log likelihood 61 .29 0 0.311626 Limit Points LIMIT_2:C(3) LIMIT_3:C(4) LIMIT_4:C(5) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.007509 32.077312 -315881.03864 Std.21363 350.A. LR statistic Prob(LR statistic) 0.021372 0.1.005775 0.000289 0.1. log likelihood Avg.2 Ordered Probit Results: 4 Ordered Values Dependent Variable: AJ Method: ML .077363 27313.3568 Prob.98297 96.190472 0.077487 2.5 -329538.002302 z-Statistic 73.005798 0.Ordered Probit (Quadratic hill climbing) Sample (adjusted): 2 304131 Included observations: 304130 after adjustments Number of ordered indicator values: 4 Convergence achieved after 4 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) Coefficient 0.633627 0. Error 0.7163 0 0 0 2.

002355 0.014821 0.5462 0 0 0 2.000986 z-Statistic 51. Error 0.1 -1.1.007386 -97. log likelihood Avg. log likelihood 62 . 0 0 0 Akaike info criterion Log likelihood Restr.569596 -0.47589 -34.6 -329538.46485 16.39776 247.005843 0.1.078049 2.038314 0.34188 Prob.204094 1.26616 98.041202 2.096973 Limit Points LIMIT_2:C(4) LIMIT_3:C(5) LIMIT_4:C(6) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.828335 0.000288 0.0389 Std.A.3 Ordered Probit (with Returns) Results: 4 Ordered Values Dependent Variable: AJ Method: ML .0779 27155.077839 -315960.Ordered Probit (Quadratic hill climbing) Sample (adjusted): 2 304131 Included observations: 304130 after adjustments Number of ordered indicator values: 4 Failure to improve Likelihood after 12 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) 10000*DLOG(ASK) Coefficient 0.04 0 0. LR statistic Prob(LR statistic) -0.005933 0.

LR statistic Prob(LR statistic) -2.006924 0.000382 0.Ordered Probit (Quadratic hill climbing) Sample (adjusted): 2 308749 Included observations: 307943 after adjustments Number of ordered indicator values: 10 Convergence achieved after 7 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) Coefficient 0. log likelihood 63 .666276 0.2579 327.2094 -159.7475 -162.1.258844 27118.037526 2.006894 0.A.5758 Prob.258734 -347769. Error 0.64 0 0.788901 0.01721 0.322974 0.694678 2.17413 122.8258 96.7 -361329 -1.329696 0.006929 0.85067 47.2254 100.00944 0.010998 0.129331 Std.206482 -1.538779 0.756869 -1. 0 0 Akaike info criterion Log likelihood Restr.006894 0.693844 0.006929 0.4 Ordered Probit Results: 10 Ordered Values Dependent Variable: AJ Method: ML .259114 2.1396 100.008505 -128.928 0 0 0 0 0 0 0 0 0 2.034469 0.000917 z-Statistic 90.9984 46.112367 Limit Points LIMIT_2:C(3) LIMIT_3:C(4) LIMIT_4:C(5) LIMIT_5:C(6) LIMIT_6:C(7) LIMIT_7:C(8) LIMIT_8:C(9) LIMIT_9:C(10) LIMIT_10:C(11) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.1. log likelihood Avg.

Error 0.00038 0.006997 0.096148 Limit Points LIMIT_2:C(4) LIMIT_3:C(5) LIMIT_4:C(6) LIMIT_5:C(7) LIMIT_6:C(8) LIMIT_7:C(9) LIMIT_8:C(10) LIMIT_9:C(11) LIMIT_10:C(12) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.41 0 0.6283 0 0 0 0 0 0 0 0 0 2.00953 0.393098 -0.04669 -2.A. 0 0 0 Akaike info criterion Log likelihood Restr.3 -361329 -1.7287 -251.26519 25169.265485 2. log likelihood 64 .00091 z-Statistic 54.02521 4.56097 -39.598756 -0.011008 0.007086 0.1147 -86.017039 0.000938 0.277872 -0.006998 0.1.020522 0.004221 0.251959 -0.034829 2.605194 -0.Ordered Probit (Quadratic hill climbing) Sample (adjusted): 2 308749 Included observations: 307943 after adjustments Number of ordered indicator values: 10 Failure to improve Likelihood after 9 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) 10000*DLOG(ASK) Coefficient 0.820135 0.812 -236.1.26293 -35.007086 0.49427 -85. log likelihood Avg.007077 0.26507 -348744.251127 1.6836 Prob.5 Ordered Probit (with Returns) Results: 10 Ordered Values Dependent Variable: AJ Method: ML .605993 -2.43857 216.55753 -35. LR statistic Prob(LR statistic) -3.501637 105.008402 -178.132496 Std.

129908 0.05482 -312461.Ordered Logit (Quadratic hill climbing) Sample (adjusted): 2 304131 Included observations: 304130 after adjustments Number of ordered indicator values: 4 Convergence achieved after 4 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) Coefficient 0.1 -329538.2955 Prob.003998 z-Statistic 102.483887 1.A.100335 4.001266 0.05487 34153.6436 108.027393 Std.014927 49. log likelihood 65 .054994 2.1.432993 Limit Points LIMIT_2:C(3) LIMIT_3:C(4) LIMIT_4:C(5) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.6 Ordered Logit Results: 4 Ordered Values Dependent Variable: AJ Method: ML .89648 0.96 0 0.1 -1. log likelihood Avg.1.009948 0. 0 0 Akaike info criterion Log likelihood Restr.051821 2. Error 0.0225 0 0 0 2.009847 0.6037 328. LR statistic Prob(LR statistic) 0.14077 110.

0 0 0 Akaike info criterion Log likelihood Restr.673158 0.131878 0.944117 -295624.7 Ordered Logit (with Returns) Results: 4 Ordered Values Dependent Variable: AJ Method: ML . log likelihood 66 .010676 0.016938 91.944178 67823.6104 174.31565 152.972039 Std.683 154.1.001297 0. log likelihood Avg.78533 0.955897 1.320523 Limit Points LIMIT_2:C(4) LIMIT_3:C(5) LIMIT_4:C(6) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.A.010468 0.102908 1. LR statistic Prob(LR statistic) 0. Error 0.3301 341.004354 0.3 -329536.001841 z-Statistic 101.0656 Prob.5674 0 0 0 1.626336 5.Ordered Logit (Quadratic hill climbing) Sample (adjusted): 3 304131 Included observations: 304128 after adjustments Number of ordered indicator values: 4 Convergence achieved after 5 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) 10000*DLOG(ASK) Coefficient 0.1.2 -0.94 0 0.944327 1.

29396 1.2 0 0.001351 0.022402 0.23552 2. 0 0 Akaike info criterion Log likelihood Restr. Error 0.1.0075 60.053891 0.9279 112.717831 0.194799 0.762068 -3.1.6399 112. LR statistic Prob(LR statistic) -5.011895 0.011771 0.028652 0.23525 34384.011771 0.32363 -131.011879 0.7518 313.9 -361329 -1. log likelihood Avg.04758 2.95536 108. log likelihood 67 .8 Ordered Logit Results: 10 Ordered Values Dependent Variable: AJ Method: ML .155742 0.3013 -141.2591 100.016561 -95.A.137085 -3.001594 z-Statistic 115.341132 5.117534 Std.6803 0 0 0 0 0 0 0 0 0 2.339747 1.158783 0.98525 61.729267 1.23514 -344136.Ordered Logit (Quadratic hill climbing) Sample (adjusted): 2 308749 Included observations: 307943 after adjustments Number of ordered indicator values: 10 Convergence achieved after 7 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) Coefficient 0.3382 Prob.159926 Limit Points LIMIT_2:C(3) LIMIT_3:C(4) LIMIT_4:C(5) LIMIT_5:C(6) LIMIT_6:C(7) LIMIT_7:C(8) LIMIT_8:C(9) LIMIT_9:C(10) LIMIT_10:C(11) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.011894 0.

2 -361329 -1.Ordered Logit (Quadratic hill climbing) Sample (adjusted): 2 308749 Included observations: 307943 after adjustments Number of ordered indicator values: 10 Convergence achieved after 7 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) 10000*DLOG(ASK) Coefficient 0.022654 0.012786 0.012786 0.053994 0.012554 0.2477 Prob.321246 1.318154 Limit Points LIMIT_2:C(4) LIMIT_3:C(5) LIMIT_4:C(6) LIMIT_5:C(7) LIMIT_6:C(8) LIMIT_7:C(9) LIMIT_8:C(10) LIMIT_9:C(11) LIMIT_10:C(12) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.2614 105.3644 104.9311 -118.127739 -327599.1.66 0 0.2298 151.1.012556 0.286633 -2.9 Ordered Logit (with Returns) Results: 10 Ordered Values Dependent Variable: AJ Method: ML .001399 0.194035 0.028848 0.5792 155.37753 -113.663842 -3. log likelihood 68 .93451 1. 0 0 0 Akaike info criterion Log likelihood Restr.128154 2.7732 146.985893 6.308867 1.253184 0.A.984385 1.012762 0. Error 0.00173 0.093349 2.3148 330.3986 0 0 0 0 0 0 0 0 0 2.3672 173. log likelihood Avg.681408 1. LR statistic Prob(LR statistic) -4.018747 -86.063831 Std.2056 155.001836 z-Statistic 113.15917 0.127859 67459.

A.1.2 A.1.2.1

Dataset 2: USD-USD April 1989 to June 1989: MA(1)-GARCH(1,1) Results:

Dependent Variable: 10000*DLOG(ASK) Method: ML - ARCH Sample (adjusted): 2 8445 Included observations: 8444 after adjustments Convergence achieved after 37 iterations MA Backcast: 1 Presample variance: backcast (parameter = 0.7) GARCH = C(3) + C(4)*RESID(-1)^2 + C(5)*GARCH(-1) Variable C MA(1) Coefficient 0.045205 -0.3281 Variance Equation C RESID(-1)^2 GARCH(-1) R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat Inverted MA Roots 0.683349 0.265029 0.653991 0.046483 0.04637 2.549771 54884.24 -18761.29 1.819609 0.33 0.025552 0.008055 0.007513 26.7437 32.9008 87.05354 0 0 0 0.001809 2.611027 4.444882 4.449051 4.446305 Std. Error 0.013771 0.011435 z-Statistic 3.282516 -28.693 Prob. 0.001 0

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter.

69

A.1.2.2

Ordered Probit Results: 4 Ordered Values

Dependent Variable: AJ Method: ML - Ordered Probit (Quadratic hill climbing) Sample (adjusted): 2 8445 Included observations: 8444 after adjustments Number of ordered indicator values: 4 Convergence achieved after 5 iterations Covariance matrix computed using second derivatives Variable GARCH01 AJ(-1) Coefficient 0.009127 0.942999 Limit Points LIMIT_2:C(3) LIMIT_3:C(4) LIMIT_4:C(5) Pseudo R-squared Schwarz criterion Hannan-Quinn criter. LR statistic Prob(LR statistic) 0.61897 1.002232 4.898957 0.115395 0.585632 0.582885 639.1806 0 0.123303 0.121611 0.134626 5.019921 8.241273 36.38941 0 0 0 0.581462 -2449.933 -2769.524 -0.290139 Std. Error 0.000855 0.042231 z-Statistic 10.67187 22.3298 Prob. 0 0

Akaike info criterion Log likelihood Restr. log likelihood Avg. log likelihood

70

A.1.2.3

Ordered Probit (with Returns) Results: 4 Ordered Values

Dependent Variable: AJ Method: ML - Ordered Probit (Quadratic hill climbing) Sample (adjusted): 2 8445 Included observations: 8444 after adjustments Number of ordered indicator values: 4 Convergence achieved after 5 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) 10000*DLOG(ASK) Coefficient 0.00933 1.008975 0.08268 Limit Points LIMIT_2:C(4) LIMIT_3:C(5) LIMIT_4:C(6) Pseudo R-squared Schwarz criterion Hannan-Quinn criter. LR statistic Prob(LR statistic) 0.775747 1.166192 5.148438 0.142475 0.568939 0.565644 789.1746 0 0.125149 0.12345 0.138288 6.198581 9.446642 37.22976 0 0 0 0.563936 -2374.936 -2769.524 -0.281257 Std. Error 0.000852 0.043056 0.006736 z-Statistic 10.94538 23.43378 12.27428 Prob. 0 0 0

Akaike info criterion Log likelihood Restr. log likelihood Avg. log likelihood

71

log likelihood 72 .158153 0.91332 3.158252 0.4 Ordered Probit Results: 10 Ordered Values Dependent Variable: AJ Method: ML .158161 0.159031 0.162967 -4.2452 0 0.0003 0.65859 -2769.0009 0 0 0 0 0.646689 2.010588 0.7664 16.07658 Prob.837742 0.463308 0. Error 0.046148 -0. LR statistic Prob(LR statistic) -1.225398 0.0036 0.195539 0.334317 27.158821 0.Ordered Probit (Quadratic hill climbing) Sample (adjusted): 2 8445 Included observations: 8444 after adjustments Number of ordered indicator values: 10 Convergence achieved after 7 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) Coefficient 0.843638 4.908998 5.000829 0.251299 0.293255 Limit Points LIMIT_2:C(3) LIMIT_3:C(4) LIMIT_4:C(5) LIMIT_5:C(6) LIMIT_6:C(7) LIMIT_7:C(8) LIMIT_8:C(9) LIMIT_9:C(10) LIMIT_10:C(11) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.525466 0. 0 0 Akaike info criterion Log likelihood Restr.191 -0. log likelihood Avg.2.644992 0.069425 0.66655 0 0 0.77686 0.71307 0.A.925167 -0.667763 0.167892 -4.327992 Std.296765 5.661721 413.104586 -3.308537 4.018241 z-Statistic 12.568 -2976.1.

2527 0.609972 0.799597 -0.653717 0.745 -2976.074509 Limit Points LIMIT_2:C(4) LIMIT_3:C(5) LIMIT_4:C(6) LIMIT_5:C(7) LIMIT_6:C(8) LIMIT_7:C(9) LIMIT_8:C(10) LIMIT_9:C(11) LIMIT_10:C(12) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.920766 -0.996988 4.0029 0.214104 6.226892 0.00409 11.64371 -2705.92919 0.823252 6.160125 0.006572 z-Statistic 13.159469 0.643716 -3. log likelihood 73 .000828 0.018435 0.673407 0.159566 0.0001 0 0 0 0 0 0.313473 0. 0 0 0 Akaike info criterion Log likelihood Restr.A.5 Ordered Probit (with Returns) Results: 10 Ordered Values Dependent Variable: AJ Method: ML . LR statistic Prob(LR statistic) -0. Error 0.197098 0.0004 0.56432 0.524124 -2.160333 0.866967 0.0003 0.205514 5.251929 28.010826 0.2.586622 0.33749 Prob.08258 17.647126 540.Ordered Probit (Quadratic hill climbing) Sample (adjusted): 2 8445 Included observations: 8444 after adjustments Number of ordered indicator values: 10 Convergence achieved after 7 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) 10000*DLOG(ASK) Coefficient 0.191 -0.320434 Std.1.804416 4. log likelihood Avg.170386 -3.09087 0.8901 0 0.991005 0.159477 0.976292 3.

Ordered Logit (Quadratic hill climbing) Sample (adjusted): 2 8445 Included observations: 8444 after adjustments Number of ordered indicator values: 4 Convergence achieved after 7 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) Coefficient 0.524505 36.221143 0.215518 0.285628 0.677 -2769.252771 5.290938 Std.524 -0.583059 -2456.078415 z-Statistic 9.587229 0.208446 9.151811 2. LR statistic Prob(LR statistic) 1.2.A.15919 Prob.6929 0 0. Error 0.023145 1.002506 0. log likelihood Avg.6 Ordered Logit Results: 4 Ordered Values Dependent Variable: AJ Method: ML .052707 9.816022 Limit Points LIMIT_2:C(3) LIMIT_3:C(4) LIMIT_4:C(5) Pseudo R-squared Schwarz criterion Hannan-Quinn criter. log likelihood 74 .73541 0 0 0 0.234157 23.1.11296 0. 0 0 Akaike info criterion Log likelihood Restr.584483 625.

023498 1.937969 0.282276 Std.542 -2769.2.7 Ordered Logit (with Returns) Results: 4 Ordered Values Dependent Variable: AJ Method: ML .A. log likelihood Avg.565974 -2383. Error 0.431605 2. LR statistic Prob(LR statistic) 1.Ordered Logit (Quadratic hill climbing) Sample (adjusted): 2 8445 Included observations: 8444 after adjustments Number of ordered indicator values: 4 Convergence achieved after 8 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) 10000*DLOG(ASK) Coefficient 0. log likelihood 75 .219477 0.36562 0 0 0 0.570977 0. 0 0 0 Akaike info criterion Log likelihood Restr.9628 0 0.567682 771.080338 0.341427 9.224685 0.1.261472 6.371611 10.002679 0.25201 Prob.66822 37.770045 0.12276 12.179594 Limit Points LIMIT_2:C(4) LIMIT_3:C(5) LIMIT_4:C(6) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.014658 z-Statistic 8.524 -0.139367 0.772378 24.

Error 0.810792 8.77277 5.399721 -2.298438 0.1.488651 0.A.191 -0.7821 0 0.068507 0.563651 Limit Points LIMIT_2:C(3) LIMIT_3:C(4) LIMIT_4:C(5) LIMIT_5:C(6) LIMIT_6:C(7) LIMIT_7:C(8) LIMIT_8:C(9) LIMIT_9:C(10) LIMIT_10:C(11) Pseudo R-squared Schwarz criterion Hannan-Quinn criter. 0 0 Akaike info criterion Log likelihood Restr.703637 3.845043 0.72951 Prob.82827 16.364009 6.328316 Std.66173 1. LR statistic Prob(LR statistic) -3.310773 -4.8 Ordered Logit Results: 10 Ordered Values Dependent Variable: AJ Method: ML .63663 0.659237 -2772.233876 3.66841 0. log likelihood 76 .286528 0.662368 407.Ordered Logit (Quadratic hill climbing) Sample (adjusted): 2 8445 Included observations: 8444 after adjustments Number of ordered indicator values: 10 Convergence achieved after 6 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) Coefficient 0.993661 -2.797737 1.030535 0.285436 0. log likelihood Avg.3 -2976.495444 -4.0012 0.0002 0 0 0 0 0.2.702359 -4.41083 28.076884 1.756259 0.033692 z-Statistic 10.00282 0.926596 1.46145 0 0 0 0.875773 6.282811 0.282485 0.282458 0.

976024 2.72067 11.289368 0.109446 -4.285722 0.64733 539.Ordered Logit (Quadratic hill climbing) Sample (adjusted): 2 8445 Included observations: 8444 after adjustments Number of ordered indicator values: 10 Convergence achieved after 8 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) 10000*DLOG(ASK) Coefficient 0.643914 -2706.286018 0.63687 0.394317 7.2. LR statistic Prob(LR statistic) -3.756454 0.387414 1.002984 0.031698 0.702375 -2.004677 1.126018 9.03419 0.62409 17.318108 -4.014728 z-Statistic 10.1676 0 0.908731 7.336144 0.440867 29.653921 0.48917 0.605872 0.9 Ordered Logit (with Returns) Results: 10 Ordered Values Dependent Variable: AJ Method: ML . log likelihood Avg.09058 0.236004 1.A.288368 0. 0 0 0 Akaike info criterion Log likelihood Restr.271391 4.167709 Limit Points LIMIT_2:C(4) LIMIT_3:C(5) LIMIT_4:C(6) LIMIT_5:C(7) LIMIT_6:C(8) LIMIT_7:C(9) LIMIT_8:C(10) LIMIT_9:C(11) LIMIT_10:C(12) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.108606 -2.191 -0.38731 Prob.320536 Std.1. Error 0.349 0 0 0 0 0 0 0 0 0 0.285744 0.607 -2976.811259 6. log likelihood 77 .243211 -4.098116 4.112879 2.

313106 950669.1.7) GARCH = C(3) + C(4)*RESID(-1)^2 + C(5)*GARCH(-1) Variable C MA(1) Coefficient 0.1 Dataset 3: USD-USD April 2006 to May 2006: MA(1)-GARCH(1.D.002535 -0.000813 0. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter.657286 3.000858 z-Statistic 7.302185 3.781719 Variance Equation C RESID(-1)^2 GARCH(-1) R-squared Adjusted R-squared S. of regression Sum squared resid Log likelihood Durbin-Watson stat Inverted MA Roots 0.902484 0.057826 0.15628 113.000558 0.2 1.3 A.Normal distribution Sample (adjusted): 2 551356 Included observations: 551355 after adjustments Convergence achieved after 14 iterations MA Backcast: 1 Presample variance: backcast (parameter = 0.ARCH (Marquardt) .372224 1. 0 0 Mean dependent var S. 78 .372225 0.302287 3.2785 1015.204 Prob.04 0 0 0 -0.075531 -911.063219 0.000889 71.78 0.3 -910333.3.1) Results: Dependent Variable: 10000*DLOG(ASK) Method: ML .302214 Std.A.000358 0.E.1.97678 0.000425 1. Error 0.

004577 0. log likelihood 79 .67524 108.1.497267 3.122714 -585179.87791 0 0 0 2.046421 -0.3. LR statistic Prob(LR statistic) -0.851 0 0.001879 z-Statistic 29.24124 -69.4 -587919. Error 0.130554 Limit Points LIMIT_2:C(3) LIMIT_3:C(4) LIMIT_4:C(5) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.267391 0.036661 -58.00466 2.061348 Std.A. 0 0 Akaike info criterion Log likelihood Restr.Ordered Probit (Quadratic hill climbing) Sample (adjusted): 2 551356 Included observations: 551355 after adjustments Number of ordered indicator values: 4 Convergence achieved after 4 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) Coefficient 0.2 Ordered Probit Results: 4 Ordered Values Dependent Variable: AJ Method: ML .122742 5479. log likelihood Avg.652 98.001588 0.624999 0.122815 2.3 -1.004557 0.46221 Prob.

00582 0.4066 121.Ordered Probit (Quadratic hill climbing) Sample (adjusted): 2 551356 Included observations: 551355 after adjustments Number of ordered indicator values: 4 Convergence achieved after 6 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) 10000*DLOG(ASK) Coefficient 0.7702 449.700167 238473.002468 0.202812 1.5486 Prob.682 0 0 0 1.84724 6.803072 1.4 -587919.520271 0.001388 z-Statistic 19.3 -0.3. log likelihood 80 .001698 0. log likelihood Avg.700133 -468682.850056 Std.3 Ordered Probit (with Returns) Results: 4 Ordered Values Dependent Variable: AJ Method: ML .264271 0.8 0 0.1.4683 317. LR statistic Prob(LR statistic) 0.032475 0. 0 0 0 Akaike info criterion Log likelihood Restr.624067 Limit Points LIMIT_2:C(4) LIMIT_3:C(5) LIMIT_4:C(6) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.005446 0. Error 0.051481 147.A.700255 1.12882 210.

3. log likelihood 81 .5938 Prob.34619 -15.004841 0.9 -1.36043 0 0 0 0 0 0 0 0 0 3.696 0 0.040361 Limit Points LIMIT_2:C(3) LIMIT_3:C(4) LIMIT_4:C(5) LIMIT_5:C(6) LIMIT_6:C(7) LIMIT_7:C(8) LIMIT_8:C(9) LIMIT_9:C(10) LIMIT_10:C(11) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.63469 96.89255 45.4 Ordered Probit Results: 10 Ordered Values Dependent Variable: AJ Method: ML .Ordered Probit (Quadratic hill climbing) Sample (adjusted): 2 551356 Included observations: 530382 after adjustments Number of ordered indicator values: 10 Convergence achieved after 5 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) Coefficient 0.005154 0.008137 0.005776 0.541017 -0. Error 0.004831 0.037289 -340.20169 -61.218854 0.351617 -888807.00484 0.001543 0.593189 0.00228 3.A. log likelihood Avg.351849 3.123895 -1.292156 -0. 0 0 Akaike info criterion Log likelihood Restr.463249 0.70278 97.0033 -60.693 -299.004827 0.6 -890838.029623 -0.1.770052 -2.33503 95.004841 0.000655 z-Statistic 19. LR statistic Prob(LR statistic) -2.675788 Std.4275 -367.076775 0.472672 3.351682 4062.

5 Ordered Probit (with Returns) Results: 10 Ordered Values Dependent Variable: AJ Method: ML .60886 112.1.084178 0.768453 -2.03649 69.3.648621 0.148442 0.005549 0.005795 0.Ordered Probit (Quadratic hill climbing) Sample (adjusted): 2 551356 Included observations: 530382 after adjustments Number of ordered indicator values: 10 Failure to improve Likelihood after 17 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) 10000*DLOG(ASK) Coefficient -0.101511 3.9 -1.509118 Std. LR statistic Prob(LR statistic) -2.00565 0.025918 -325.365238 Limit Points LIMIT_2:C(4) LIMIT_3:C(5) LIMIT_4:C(6) LIMIT_5:C(7) LIMIT_6:C(8) LIMIT_7:C(9) LIMIT_8:C(10) LIMIT_9:C(11) LIMIT_10:C(12) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.6273 Prob. log likelihood 82 .041679 0.018353 180859.001544 0.006173 0.000821 0.9393 0 0 0 0 0 0 0 0 0 3.659757 4.5115 -262.018282 -800409.7437 -26.6 0 0.005789 0.008501 0.6782 -338.395925 0.035043 0. log likelihood Avg. Error 0. 0 0 0 Akaike info criterion Log likelihood Restr.089688 -1.56212 298.001223 z-Statistic -22.74997 15.69168 22.0419 113.005688 0.1 -890838.8488 155.01852 0.018535 3.005598 0.484632 -0.A.

20336 108.007581 0. 0 0 Akaike info criterion Log likelihood Restr.123324 5159.003055 z-Statistic 28.6 Ordered Logit Results: 4 Ordered Values Dependent Variable: AJ Method: ML .144521 -54. log likelihood Avg.1.Ordered Logit (Quadratic hill climbing) Sample (adjusted): 2 551356 Included observations: 551355 after adjustments Number of ordered indicator values: 4 Convergence achieved after 4 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) Coefficient 0.4198 63.21045 0 0 0 2.830244 9.123295 -585339.123397 2. LR statistic Prob(LR statistic) -0.41091 0.135262 0.080152 -0.061638 Std.79117 Prob. log likelihood 83 .321 0 0.00277 0.A.004388 2.93061 -66.204018 Limit Points LIMIT_2:C(3) LIMIT_3:C(4) LIMIT_4:C(5) Pseudo R-squared Schwarz criterion Hannan-Quinn criter. Error 0.3.3 -1.7 -587919.007658 0.

600267 3.A.85304 229.3 -0. log likelihood Avg.671713 254162.5789 81.671801 1.167398 160.7016 312.3 0 0. Error 0.011048 0. LR statistic Prob(LR statistic) 1. log likelihood 84 .003264 0.1 -587919.048475 1.3.453473 13.7 Ordered Logit (with Returns) Results: 4 Ordered Values Dependent Variable: AJ Method: ML .009958 0.216154 1.002966 z-Statistic 14.671678 -460838.053246 1.6294 0.6602 409.1.215211 Limit Points LIMIT_2:C(4) LIMIT_3:C(5) LIMIT_4:C(6) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.7483 Prob.835828 Std.41909 0 0 0 1.004586 0.Ordered Logit (Quadratic hill climbing) Sample (adjusted): 2 551356 Included observations: 551355 after adjustments Number of ordered indicator values: 4 Convergence achieved after 6 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) 10000*DLOG(ASK) Coefficient 0. 0 0 0 Akaike info criterion Log likelihood Restr.

A.07549 Limit Points LIMIT_2:C(3) LIMIT_3:C(4) LIMIT_4:C(5) LIMIT_5:C(6) LIMIT_6:C(7) LIMIT_7:C(8) LIMIT_8:C(9) LIMIT_9:C(10) LIMIT_10:C(11) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.3316 -62.841 0 0.350102 3.147643 -265.512979 -0.349936 4988.12349 -20. 0 0 Akaike info criterion Log likelihood Restr.22038 61.001114 z-Statistic 22.4939 -290.61812 86.168038 0. log likelihood 85 . log likelihood Avg.1.008257 0.002706 0.9 -1.78632 Prob.8 Ordered Logit Results: 10 Ordered Values Dependent Variable: AJ Method: ML .965107 -2.73051 9.7677 -339. Error 0.41918 37.5 -890838.Ordered Logit (Quadratic hill climbing) Sample (adjusted): 2 551356 Included observations: 530382 after adjustments Number of ordered indicator values: 10 Convergence achieved after 5 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) Coefficient 0.0028 3.008229 0.714603 0.008227 0.011679 0.009268 0. LR statistic Prob(LR statistic) -5.32978 88.20197 0 0 0 0 0 0 0 0 0 3.12459 -67.059869 -0.036028 0.008278 0.3095 0.690845 -0.3.34987 -888344.008281 0.681481 -3.021378 0.674915 Std.

528082 3.9 -890838.18593 251.867227 261014.6353 286.9 -1.8036 -165.846774 3.402995 1.867409 2.9 Ordered Logit (with Returns) Results: 10 Ordered Values Dependent Variable: AJ Method: ML .1774 329. LR statistic Prob(LR statistic) -3.1.1 0 0.3.04924 2.067262 0.146499 2.011692 0. log likelihood Avg.011271 0.0122 330.010767 0.A.54475 190.Ordered Logit (Quadratic hill climbing) Sample (adjusted): 2 551356 Included observations: 530382 after adjustments Number of ordered indicator values: 10 Convergence achieved after 6 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) 10000*DLOG(ASK) Coefficient 0.7165 2.0016 0. Error 0.003175 0.002737 z-Statistic 21.114505 -0.011712 0.872262 13.225475 3.6322 81.94908 0.010738 0.170499 -176.0968 -66.9007 434.867156 -760331.8341 231. log likelihood 86 .433555 Std.4841 Prob.022026 0.189108 Limit Points LIMIT_2:C(4) LIMIT_3:C(5) LIMIT_4:C(6) LIMIT_5:C(7) LIMIT_6:C(8) LIMIT_7:C(9) LIMIT_8:C(10) LIMIT_9:C(11) LIMIT_10:C(12) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.012808 0. 0 0 0 Akaike info criterion Log likelihood Restr.010914 0.894364 -2.81305 0 0 0 0 0 0 0 0 0 2.

36927 0.196973 Std.051345 0.A.001 0 0 0 -0.000386 1.1 Dataset 4: USD-USD April 2009 to May 2009: MA(1)-GARCH(1.000251 0.1) Results: Dependent Variable: 10000*DLOG(ASK) Method: ML .000225 0.00021 0.002329 -0.001 Prob.0686 3502.4 A.000611 z-Statistic 9.045284 0. 0 0 Mean dependent var S.78 0.D.970126 0.1.6421 244.1.E.78024 Variance Equation C RESID(-1)^2 GARCH(-1) R-squared Adjusted R-squared S.4.272934 1631271 -1609241 1. of regression Sum squared resid Log likelihood Durbin-Watson stat Inverted MA Roots 0.196957 3.000263 201.274136 -1276.ARCH Sample (adjusted): 2 1006737 Included observations: 1006736 after adjustments Convergence achieved after 21 iterations MA Backcast: 1 Presample variance: backcast (parameter = 0.7) GARCH = C(3) + C(4)*RESID(-1)^2 + C(5)*GARCH(-1) Variable C MA(1) Coefficient 0.919658 0.602816 3.369269 1. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Error 0.197016 3. 87 .

069833 2.8863 177.A.262245 Limit Points LIMIT_2:C(3) LIMIT_3:C(4) LIMIT_4:C(5) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.1.024794 2.Ordered Probit (Quadratic hill climbing) Sample (adjusted): 2 1006737 Included observations: 1006736 after adjustments Number of ordered indicator values: 4 Convergence achieved after 3 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) Coefficient 0. LR statistic Prob(LR statistic) 0.000867 0. Error 0.45 0 0.00148 z-Statistic 113.4.098754 0.392075 0.003801 99.1729 Prob.069791 52977. log likelihood 88 .034882 Std.003373 0.003019 0. log likelihood Avg. 0 0 Akaike info criterion Log likelihood Restr.50314 532.8891 629.797373 2.300383 1.2 Ordered Probit Results: 4 Ordered Values Dependent Variable: AJ Method: ML .366 0 0 0 2.069774 -1041853 -1068342 -1.

Error 0.260624 0.420409 0.7 0 0.415817 Limit Points LIMIT_2:C(4) LIMIT_3:C(5) LIMIT_4:C(6) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.741812 2.000907 0.6876 Prob.7718 146.3 Ordered Probit (with Returns) Results: 4 Ordered Values Dependent Variable: AJ Method: ML .Ordered Probit (Quadratic hill climbing) Sample (adjusted): 2 1006737 Included observations: 1006736 after adjustments Number of ordered indicator values: 4 Convergence achieved after 12 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) 10000*DLOG(ASK) Coefficient 0. LR statistic Prob(LR statistic) 0.748173 1. 0 0 0 Akaike info criterion Log likelihood Restr.10602 429.A.00095 z-Statistic 44.4.040619 0.7516 0 0 0 1.004675 21.1621 517.874046 Std.072632 1.748122 376817.004059 0. log likelihood Avg.176356 1.001785 0.0215 437.1 -1068342 -0.748103 -879933.1.003441 0. log likelihood 89 .

8967 Prob.003495 -410.003573 0.002717 0.4852 -62.058805 -2043062 -2076824 -2.096416 0. Error 0. LR statistic Prob(LR statistic) -1.9753 170.05884 67525.003034 0.0911 212.002774 0.0574 685. log likelihood Avg.1.32063 0.5626 549.4 Ordered Probit Results: 10 Ordered Values Dependent Variable: AJ Method: ML .630826 1.463947 0.058934 4. log likelihood 90 .Ordered Probit (Quadratic hill climbing) Sample (adjusted): 2 1006737 Included observations: 1006736 after adjustments Number of ordered indicator values: 10 Convergence achieved after 4 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) Coefficient 0.002729 0.38151 52.394888 0.855945 1.000823 0.169471 0.466867 -0.029392 Std.799457 2.002965 0.67088 117.9868 593. 0 0 Akaike info criterion Log likelihood Restr.000415 z-Statistic 117.47 0 0.002718 0.088372 Limit Points LIMIT_2:C(3) LIMIT_3:C(4) LIMIT_4:C(5) LIMIT_5:C(6) LIMIT_6:C(7) LIMIT_7:C(8) LIMIT_8:C(9) LIMIT_9:C(10) LIMIT_10:C(11) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.016257 4.A.4.2099 0 0 0 0 0 0 0 0 0 4.142757 0.0266 308.00271 0.

481455 1.09902 -4.096012 3.000502 0.5108 Prob.729889 3.211211 -0.094896 0. LR statistic Prob(LR statistic) -1.40264 0.003255 0.A. log likelihood Avg.8559 0 0 0 0 0 0 0 0 0 3.0877 413.003579 0.003697 0.889585 -0.004378 -501.9157 468.399614 Limit Points LIMIT_2:C(4) LIMIT_3:C(5) LIMIT_4:C(6) LIMIT_5:C(7) LIMIT_6:C(8) LIMIT_7:C(9) LIMIT_8:C(10) LIMIT_9:C(11) LIMIT_10:C(12) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.002964 0.753915 49.24206 189.729787 398801. log likelihood 91 .1.003113 0.729748 -1877424 -2076824 -1.014555 0.864862 Std.8783 453.003013 0.4773 -70.540899 -0.003187 0.000829 0.4845 548.5 Ordered Probit (with Returns) Results: 10 Ordered Values Dependent Variable: AJ Method: ML . 0.4.0001 0 0 Akaike info criterion Log likelihood Restr. Error 0.615502 1.00377 0.843887 188.676514 2.Ordered Probit (Quadratic hill climbing) Sample (adjusted): 2 1006737 Included observations: 1006736 after adjustments Number of ordered indicator values: 10 Convergence achieved after 9 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) 10000*DLOG(ASK) Coefficient -0.000853 z-Statistic -3.2568 -182.153294 0.003062 0.1 0 0.

0 0 Akaike info criterion Log likelihood Restr.006332 0.574 169.3761 0 0 0 2.070184 -1042059 -1068342 -1.070243 2.214626 0.01 0 0.002593 z-Statistic 109.A.6 Ordered Logit Results: 4 Ordered Values Dependent Variable: AJ Method: ML .00533 0.1.0702 52565.007555 111.024601 2.035087 Std. log likelihood Avg.3912 491.593662 3.001959 0.114943 4.301442 0.9238 569. log likelihood 92 . LR statistic Prob(LR statistic) 0.43948 Limit Points LIMIT_2:C(3) LIMIT_3:C(4) LIMIT_4:C(5) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.4. Error 0.Ordered Logit (Quadratic hill climbing) Sample (adjusted): 2 1006737 Included observations: 1006736 after adjustments Number of ordered indicator values: 4 Convergence achieved after 4 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) Coefficient 0.4684 Prob.

A.5 0 0.222491 1. Error 0.1713 Prob.766256 Std.964362 1.6543 585.992082 6. LR statistic Prob(LR statistic) 2.012206 406.532594 1.532543 593849.4.1.002315 0.27793 1.007366 0.2 -1068342 -0.38648 Limit Points LIMIT_2:C(4) LIMIT_3:C(5) LIMIT_4:C(6) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.7 Ordered Logit (with Returns) Results: 4 Ordered Values Dependent Variable: AJ Method: ML . log likelihood 93 . log likelihood Avg.010304 0.2264 659.504201 0.532523 -771417. 0 0 0 Akaike info criterion Log likelihood Restr.Ordered Logit (Quadratic hill climbing) Sample (adjusted): 2 1006737 Included observations: 1006736 after adjustments Number of ordered indicator values: 4 Convergence achieved after 5 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) 10000*DLOG(ASK) Coefficient 0.003971 0.7327 0 0 0 1.6204 696.002369 z-Statistic 96.11273 494.796605 8.

000728 z-Statistic 110.297395 0.1.005723 0.4.204722 0.4985 0 0 0 0 0 0 0 0 0 4.4991 543.496184 2.187268 0. log likelihood Avg.004891 0.8 Ordered Logit Results: 10 Ordered Values Dependent Variable: AJ Method: ML .059952 4.149279 Limit Points LIMIT_2:C(3) LIMIT_3:C(4) LIMIT_4:C(5) LIMIT_5:C(6) LIMIT_6:C(7) LIMIT_7:C(8) LIMIT_8:C(9) LIMIT_9:C(10) LIMIT_10:C(11) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.863371 1.5268 297.001844 0.01601 4.5 0 0.004859 0.005024 0.A. 0 0 Akaike info criterion Log likelihood Restr.004866 0.059859 66500.005538 0.48186 70.004839 0.795295 -0.007967 0.112486 4.8518 -38.812 612.07788 129.0571 Prob.8187 176.Ordered Logit (Quadratic hill climbing) Sample (adjusted): 2 1006737 Included observations: 1006736 after adjustments Number of ordered indicator values: 10 Convergence achieved after 4 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) Coefficient 0. log likelihood 94 .059823 -2043574 -2076824 -2.9948 205. Error 0.630813 0.029901 Std.8132 506.007016 -350. LR statistic Prob(LR statistic) -2.339075 0.804875 3.

006789 0. LR statistic Prob(LR statistic) -1.Ordered Logit (Quadratic hill climbing) Sample (adjusted): 2 1006737 Included observations: 1006736 after adjustments Number of ordered indicator values: 10 Convergence achieved after 5 iterations Covariance matrix computed using second derivatives Variable GARCHVAR AJ(-1) 10000*DLOG(ASK) Coefficient 0.9462 765.001961 z-Statistic 124.47405 3.010167 -177.5891 574.549476 2.6506 443. 0 0 0 Akaike info criterion Log likelihood Restr. log likelihood 95 . log likelihood Avg.734323 3.3935 382.283457 Limit Points LIMIT_2:C(4) LIMIT_3:C(5) LIMIT_4:C(6) LIMIT_5:C(7) LIMIT_6:C(8) LIMIT_7:C(9) LIMIT_8:C(10) LIMIT_9:C(11) LIMIT_10:C(12) Pseudo R-squared Schwarz criterion Hannan-Quinn criter.473948 656363.575528 1.034615 5.285226 7.1.005795 0.007889 0.959922 0.005979 0.473909 -1748643 -2076824 -1.4871 Prob.85286 6.A.6451 488.736943 Std.4.2899 741.006163 0.9249 0 0 0 0 0 0 0 0 0 3.008209 0.8769 594.006343 0.288018 2.1 0 0.6376 782.268841 0.499334 1.002158 0.5703 267.9 Ordered Logit (with Returns) Results: 10 Ordered Values Dependent Variable: AJ Method: ML . Error 0.100859 4.158021 3.008444 0.001002 0.3314 654.

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