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. Investing

    What Does Bid And Asked Mean?

    Bid and asked is a two-way price quotation.
  4. Trading

    Why Financial Spread Betting Gets a Bad Rap

    Spread betting lets speculators trade on price movements. Investors predict whether the spread between the bid price and the ask price will rise or fall.
  5. Investing

    What Is Spread Betting?

    The temptation and perils of being over leveraged is a major pitfall of spread betting. However, the low capital outlay necessary, risk management tools available and tax benefits make spread ...
  6. Insights

    How Commodities Spread Betting Works

    Commodity spread betting is a way to speculate on price movements of various commodities. Here's how it works.
  7. Investing

    Understanding Yield Spread

    Yield spread is the difference in yields between debt instruments.
Frequently Asked Questions
  1. What are the main segments of the real estate sector?

    Identify the three primary segments of the real estate sector and the metrics used by investors and analysts to gauge the ...
  2. What Are the Components of a Risk Premium?

    Learn the five main risks that comprise the risk premium and how they affect investors.
  3. How do university endowments work?

    Endowments are financial assets donated to universities or colleges. Here's how they work.
  4. Which of the Following Accounts Does ERISA Cover?

    A—IRA, B—State employee pension plan, C—Corporate defined-benefit plan, D—Coverdell savings account.
Trading Center