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:

Formula 5.1

% Spread = 100 × (Ask Price - Bid Price)
                                     Ask Price

Example: Bid-Ask Spread
Suppose that a dealer provides the following quote in the U.S. for euros to dollars:

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

Related Articles
  1. Trading

    Understanding The Spread in Retail Currency Exchange Rates

    Understanding how exchange rates are calculated and shopping around for the best rates may mitigate the effect of wide spreads in the retail forex market.
  2. Investing

    What is Spread?

    Spread has several slightly different meanings depending on the context. Generally, spread refers to the difference between two comparable measures.
  3. Trading

    Retail FX Spreads: Do They Even Matter?

    Learn how retail forex spreads affect your ability to trade currencies.
  4. Investing

    Penny Stocks

    Learn more about this cheap stock and how its high risk nature, large bid-ask spreads and lack of liquidity may not make it the most wise investment.
  5. Trading

    The Basics Of The Bid-Ask Spread

    The bid-ask spread is essentially a negotiation in progress. To be successful, traders must be willing to take a stand and walk away in the bid-ask process through limit orders.
Frequently Asked Questions
  1. What Factors Cause Shifts in Aggregate Demand?

    Find out how aggregate demand is calculated in macroeconomic models. See what kinds of factors can cause the aggregate demand ...
  2. Who are Whole Foods' (WFM) main competitors?

    Learn more about Whole Foods Markets, who insists its products are sustainable. Thanks to the competition, however, its marketing ...
  3. What are the Differences Between Ex Works (EXW) and Free On Board (FOB)?

    Learn about Ex Works and Free on Board, the main difference between these Incoterms, and the responsibilities of buyers and ...
  4. What are Common Examples of Monopolistic Markets?

    Discover what causes real instances of market monopoly, how it persists and where monopoly privilege is most common in the ...
Trading Center