What determines transaction costs in foreign exchange markets?

Using detailed data on the currency transactions of institutional fund managers, this paper shows that funds that experience high returns on their currency holdings also incur lower transaction costs on their currency trades. This finding holds both in the cross section, i.e. funds that perform better on average incur lower average transaction costs, as well as in time series, i.e. funds that do better over the past two months incur lower transaction costs on subsequent transactions. The results are consistent with foreign exchange dealers bidding for information from successful traders. They are also consistent with foreign exchange dealers exploiting price inelastic demand for foreign currency trades, or funds acting as secondary liquidity providers in foreign exchange markets. The paper also investigates the role of fund size, transaction frequency and return volatility on transactions costs. Copyright (c) 2007 John Wiley & Sons, Ltd.