Calculating Spread on a Foreign Currency Quote
Profits for currency market dealers are derived from the difference between the bid, which is the exchange rate at which a dealer is willing to purchase a particular currency, and the ask, which is the exchange rate for which a dealer is willing to sell a particular currency.
The difference between the two is called the bid-ask spread. Foreign currency dealers will quote both a bid and an ask for a particular currency. The average of the bid and ask (ask plus bid divided by two) is referred to as the midpoint price. The bid-ask spread is usually given as a percentage and it is calculated as:
% Spread = 100 × (Ask Price - Bid Price)
Example: Bid-Ask Spread
Suppose that a dealer provides the following quote in the
Direct ($/¬): $0.8038/$0.8041
Then the bid-ask spread will be 100 × (0.8041 - 0.8038) / 0.8041 = 0.0373%, which is about 4 bps.
Factors Influencing the Size of Spreads
Factors that affect the size of spreads for spot or forward currency exchange rates include:
- Trading Volume - The higher the volume, or the more active a market, the lower the bid-ask spread.
- Currency Rate Volatility - With higher volatility, currency dealers are exposed to higher risk. Spreads will increase with higher volatility.
- Perceived Economic/Political Risks - Risks such as political instability, higher inflation and changing economic conditions will affect the spreads associated with a particular currency. The higher the uncertainty, the greater the expected spread.
Note that if a dealer has an overly large position in a currency relative to the desired net position, the dealer will alter the midpoint of the spread rather than adjust the spread. For instance, a dealer with a shortage of a particular currency will move the midpoint of the direct quote up. Competition is also an important factor for spreads. A dealer with an overly large spread will not be making trades.
Spot Market Calculations
InvestingIt's very important for every investor to learn how to calculate the bid-ask spread and factor this figure when making investment decisions.
InvestingIn a dealer market, market participants buy and sell through dealers who are designated as market makers.
TradingUnderstanding how exchange rates are calculated and shopping around for the best rates may mitigate the effect of wide spreads in the retail forex market.
TradingFutures investors flock to spreads because they hold true to fundamental market factors.
InvestingSpread has several slightly different meanings depending on the context. Generally, spread refers to the difference between two comparable measures.
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