Calculating Foreign Exchange Spread

Calculating bid-ask spreads for foreign currencies

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. 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.

 

Foreign Exchange Spread

 

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:

 

Foreign Exchange Spread

 

Where:

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” refers to the theoretical price at which there would be a trade (assuming that there is always a bid-ask spread). The number can be calculated by adding together the ask price and the bid price and then dividing the resulting number 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 would be (1.50+1.00)/2 = US$1.25.

 

Factors that influence the bid-ask 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 active forex market, while implies a lower bid-ask spread. It is because as the bid-ask spread decrease, so does the discrepancy between dealers and buyers in 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.

Conversely, a buyer is able to find a dealer more easily who is willing to take him up on his offer to buy the currency for a certain price. The opposite is also true; higher bid-ask 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 will 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 bid-ask spread will become larger. It is because dealers will perceive the currency as a high-risk investment, and thus will have no choice but to sell the currency at a premium in anticipation of higher investor returns.

In addition, bidders will not consider the currency a viable investment and will offer lower and lower price for it. Thus, the bid-ask spread will widen and, as discussed above, 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. The additional risk usually exposes currency dealers to more risk as it compromises the certainty of their returns. As a result, dealers will push ask prices higher, which will, in turn, drive the bid-ask spread upward.

 

More Resources

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