Sunday, October 02, 2011

Spread Calculations

CFA Level 1 - Global Economic Analysis

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:

                               Bid                Ask

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.

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