Analysis of Spreads in the Dollar/Euro and Deutsche Mark/Dollar Foreign Exchange Markets

We compute bid-ask spreads for the dollar/euro exchange rate and find them to be substantially larger than their deutschemark counterparts before introduction of the euro. We show that larger percentage spreads are not explained by volatility, trade intensity, and other standard explanatory variables in our data sets. But we also show that spreads have not increased in terms of the unit ('pip') used in exchange rate quotations to the fourth decimal point. Since the euro is worth about two marks, and was initially worth more than a dollar, this finding suggests that larger percentage spreads reflect the more pronounced 'granularity' of quoting conventions in euro-dollar rather than dollar-mark trading. We discuss whether mandating quotations to the fifth decimal might be advisable, and conclude that such a policy might, but need not, increase the foreign exchange market's liquidity