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BIS WORKING PAPERS No 93 – October 2000

TRADING VOLUMES, VOLATILITY AND SPREADS IN FOREIGN EXCHANGE MARKETS: EVIDENCE FROM EMERGING MARKET COUNTRIES

by

Gabriele Galati

BANK FOR INTERNATIONAL SETTLEMENTS Monetary and Economic Department Basel, Switzerland

BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS.

Copies of publications are available from: Bank for International Settlements Information, Press & Library Services CH-4002 Basel, Switzerland Fax: +41 61 / 280 91 00 and +41 61 / 280 81 00 This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2000. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISSN 1020-0959

BIS WORKING PAPERS No 93 – October 2000

TRADING VOLUMES, VOLATILITY AND SPREADS IN FOREIGN EXCHANGE MARKETS: EVIDENCE FROM EMERGING MARKET COUNTRIES

by

Gabriele Galati*

Abstract This paper provides empirical evidence on the relationship between trading volumes, volatility and bid-ask spreads in foreign exchange markets. It uses a new data set that includes daily data on trading volumes for the dollar exchange rates of seven currencies from emerging market countries. The sample period is 1 January 1998 to 30 June 1999. The results are broadly consistent with the findings of the literature that used futures volumes as proxies for total foreign exchange trading. I find that in most cases unexpected trading volumes and volatility are positively correlated, suggesting that both are driven by the arrival of public information, as predicted by the mixture of distributions hypothesis. I also find that the correlation between trading volumes and volatility is positive during “normal” periods but turns negative when volatility increases sharply. Finally, the results suggest that volatility and spreads are positively correlated, as suggested by inventory cost models. However, contrary to the prediction of these models, I do not find evidence of a significant impact of unexpected trading volumes on spreads.

* I thank Javiera Aguilar, Claudio Borio, Alain Chaboud, Stefan Gerlach, Bob McCauley, Eli Remolona and Kostas Tsatsaronis for helpful comments and Florence Béranger and Anna Cobau for research assistance.

Contents

1.

Introduction ...................................................................................................................

1

2.

Literature review ...........................................................................................................

2

3.

The data ......................................................................................................................... Exchange rates .................................................................................................... Volatility ............................................................................................................. Trading volumes ................................................................................................. Spreads ................................................................................................................

5 5 6 7 9

4.

Volumes, volatility and spreads .................................................................................... 10 Trading volumes and volatility ........................................................................... 10 Trading volumes and bid-ask spreads ................................................................. 13

5.

Conclusions...
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