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Foreign exchange market bid-ask spread and market power in an underdeveloped economy

Khemraj, Tarron and Pasha, Sukrishnalall (2008): Foreign exchange market bid-ask spread and market power in an underdeveloped economy.

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This paper explores the influence of trader (or cambio) market power in determining the foreign exchange market bid-ask spread. It presents a theoretical model that incorporates the notion of oligopolistic market power into the foreign exchange market. The econometric results are consistent with the hypothesis of oligopolistic trader market power. Moreover, the results confirm the prediction of standard market microstructure theory that volatility exerts a positive effect on spread. We also uncovered a positive relationship between liquidity (the quantity of foreign exchange traded) and spread, a result which differs from the existing literature. We interpret this finding to mean that oligopolistic traders set the mark-up exchange rate above where the purely competitive rate would have been so as to generate a surplus of US$ that is then hoarded. The econometric exercise utilizes a unique data set of trading volumes and buying/selling exchange rates for each cambio from January 2000 to December 2007. It must be emphasized early that this data are not order flows. Our data measure realized trading volumes and prices.

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