What is the Foreign Exchange Spread?
The foreign exchange spread (or bid-ask spread) refers to the difference in the bid and ask prices for a given currency pair. The bid price refers to the maximum amount that a foreign exchange trader is willing to pay to buy a certain currency, and the ask price is the minimum price that the currency dealer is willing to accept for the currency.
How can we calculate the foreign exchange spread?
The foreign exchange spread is usually expressed as a percentage, and can be calculated using the formula below:
Ask Price – Refers to the lowest price that a currency dealer is willing to sell units of the currency for
Bid Price – Refers to the highest price that a currency trader is willing to buy units of the currency for
Thus, traders and dealers are able to exploit different parties’ valuation of the given currency and profit from the discrepancy. In some cases, the argument can be made that certain forex trades follow the Greater Fool Theory, which exploits environments where there is asymmetrical information.
The “midpoint” of the foreign exchange spread refers to the theoretical price at which there would be a trade. It can be calculated by adding the ask and bid prices and then dividing the sum by two.
For example, if a dealer is willing to sell a certain number of units of a given currency for the equivalent of US$1.50, whereas a trader is only willing to buy a number of the currency units for US$1.00, the midpoint price of the foreign exchange spread would be (1.50+1.00)/2 = US$1.25.
Factors that influence the foreign exchange spread
There are a great number of factors that can affect the magnitude of bid-ask spreads that prevail on certain trading floors. For example:
1. Trading volumes
Generally speaking, higher trading volumes are indicative of a more liquid market, which implies a lower bid-ask spread. As the foreign exchange spread decreases, so does the discrepancy between dealer and buyer valuations of the currency. Therefore, dealers are able to more easily find a buyer with a similar bid price to their ask price and proceed with a trade.
Likewise, a buyer is able to find a dealer more easily who is willing to accept their offer to buy the currency for a certain price.
Higher foreign exchange spreads typically signify lower trading volumes since buyers and dealers have greater difficulty finding a willing trade partner.
2. Economic/Political risks
Nations that experience tumultuous political climates or unstable economies typically have their currencies associated with high risk. Such economies usually have fairly high inflation rates and are do not have a disciplined approach to monetary policy. As a result of this, the foreign exchange spread will become larger. This is because dealers will perceive the currency as a high-risk investment, and thus will only sell the currency at a premium. Buyers seek to buy at a discount to compensate for the higher risk.
Thus, the bid-ask spread will widen and, as noted, trade volumes will decrease.
3. Currency volatility
If a currency is not supported by disciplined monetary policy and a stable central bank, it is usually more susceptible to changes in value. As a result, dealers will push ask prices higher, which will, in turn, drive the bid-ask spread upward.
We hope you’ve enjoyed reading CFI’s explanation of Foreign Exchange Spread. CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources: