Research Discussion Paper – RDP 8707 Asymmetric Information and Bid-ask Spreads in the Eurocurrency Markets
October 1987
Abstract
The paper develops a model of the determination of bid-ask spreads for a security dealer. The size of the equilibrium bid-ask spread is shown to depend on parameters describing the information structure of the model. Other things being equal, the spread is an increasing function of the dealer's uncertainty about what his customers know, and is a decreasing function of the variance of noise in the market. Empirically, this stylised result suggests that bid-ask spreads may be significant predictors of the distribution of future asset prices; this is supported using data for the Eurocurrency markets.