The Bid-offer Spread

An exchange rate is the price of the base currency expressed in terms of the price currency. For example, assume that the USD/CAD rate is 0.7625. This implies that the Canadian dollar, the base currency, costs 0.7625 US dollars (One Canadian dollar is worth 0.7625 US dollars).

Note: You might come across different notations in different sources. For consistency, we will quote exchange rates using the convention “P/B,” where the price of base currency “B” is expressed in terms of the price currency “P.” CFA Institute’s convention for exchange rate quotations is the reverse of what you see on most forex websites.

The currency exchange rate for immediate delivery is called the spot exchange rate. On the other hand, the rate for an exchange to be done in the future is called the forward exchange rate.

The spot exchange rate is used for settlement on day T + 2, the second business day following the trade date. The only exception is CAD/USD, where the standard settlement is T + 1. In most financial markets, potential counterparties quote a two-sided price for market participants: the bid price and the offer price.

The bid price is expressed in terms of the price currency. It is the price at which a counterparty is willing to buy one unit of the base currency. On the other hand, the offer price is expressed in terms of the price currency. It is the price at which that counterparty is ready to dispose of (sell) one unit of the base currency. For example, a dealer might quote a USD/EUR exchange rate of 1.3849/1.3851. What does this imply?

This quote implies that the dealer is willing to pay USD 1.3849 to buy 1 euro. On the flip side, they are prepared to sell 1 euro for USD 1.3851. Intuitively, we expect the bid price to be slightly less than the offer price because the dealer’s goal is to make a profit in every transaction. With that in mind, given a quote, it is easier to single out the bid price or the offer price.

The bid-offer spread is the amount by which the offer price exceeds the bid price. It is the difference between the highest price a purchaser is willing to pay and the least amount a seller is willing to accept.

Characteristics of Bid-offer Quotes

1. The offer price should always be higher than the bid price.
2. A market participant requesting the two-sided price quote has the option but not the obligation to transact at either the bid or the offer quoted by a dealer. If a party decides to trade at the quoted prices, they are said to have “hit the bid” or “paid the offer.” In other words, if a trader decides to sell to a dealer at the (dealer’s) bid price, they are said to hit the bid. If they decide to buy at the offer price, they are said to have paid the offer.

Although most transactions involve a dealer and a client, dealers often transact amongst themselves in an environment referred to as the interbank market. Sales in the interbank market are usually large and involve at least a million units of the base currency.

The bid-offer spread is usually narrower in the interbank market than in the dealer-client market. This implies that dealers offer their fellow dealers slightly more favorable rates. Almost all currencies are quoted to four decimal places except the Japanese Yen, usually quoted to two decimal places. The last decimal point is called a pip.

Example: Calculating the Bid-offer Spread

The USD/GBP spot market rate is quoted at 1.3849/1.3851 in the interbank market. A dealer in the same market quotes the same spot rate as 1.3847/1.3852. Calculate the bid-offer spread in each case.

Solution

For the interbank quote, the spread is 2 pips wide (1.3851 – 1.3849 = 0.0002), while the dealer-client quote is 5 pips wide (1.3852 – 1.3847 = 0.0005).

In both cases, the bid-offer spread represents the compensation sought by a party in exchange for providing liquidity to other market participants.

Factors Affecting the Bid-offer Spread

The size of the bid-offer spread depends primarily on the following three factors:

1. The bid-offer spread in the interbank foreign exchange market for the two currencies involved: The spread in the interbank market is directly proportional to the spread in the dealer-client market. As the spread in the interbank market increases (decreases), the spread in the dealer-client market increases (decreases).
2. The transaction size: The spread increases as the transaction size increases to reflect the difficulties the dealer faces while trying to offset the risk of the position in the interbank market. For example, a client eyeing a transaction to the tune of $100 million will receive a wider spread than another client whose deal is worth, say, $10 million.
3. The relationship between the dealer and the client: For instance, a seasoned (repeat) client might be provided with a spread smaller than that offered to a first-time client.

Question

Which of the following statements is least likely accurate?

1. The bid-offer spread is the difference between the offer price and the bid price.
2. The bid-offer spread is wider for larger transactions in the FX market.
3. The offer price is always smaller than the bid price.

Solution

The correct answer is C.

The offer price is always higher than the bid price since the market maker wants to make money for providing liquidity. 

Reading 8: Currency Exchange Rates: Understanding Equilibrium Value

LOS 8 (a) Calculate and interpret the bid-offer spread on a spot or forward currency quotation and describe the factors that affect the bid-offer spread.