Introduction

In foreign exchange markets, understanding bid-ask spreads is crucial for participants looking to buy or sell currencies. The bid-ask spread represents the difference between the highest price that a buyer is willing to pay (bid price) and the lowest price that a seller is willing to accept (ask price) for a particular currency pair. This chapter will delve into the mechanics of bid-ask spreads, explain how to calculate them, and highlight why the bid-ask spread for spot quotes may differ from the bid-ask spread for forward quotes.

Mechanics of Bid-Ask Spreads

The bid-ask spread is an essential component of foreign exchange pricing. When a trader wants to exchange one currency for another, they can either buy at the higher ask price or sell at the lower bid price. The difference between these two prices constitutes the bid-ask spread. For example, if the EUR/USD currency pair is quoted at 1.2000/1.2010, the bid-ask spread is 10 pips (1.2010 - 1.2000)

Calculating Bid-Ask Spread

To calculate the bid-ask spread, subtract the bid price from the ask price. The formula is as follows:

Bid-Ask Spread = Ask Price - Bid Price

For instance, if the bid price for USD/JPY is 108.50, and the ask price is 108.60, the bid-ask spread is 10 pips (108.60 - 108.50).

Differences between Spot and Forward Bid-Ask Spreads

The bid-ask spread for spot quotes may differ from the bid-ask spread for forward quotes due to several factors:

• Liquidity: Spot markets are generally more liquid than forward markets, resulting in tighter bid-ask spreads for spot quotes. Liquidity refers to the ease of buying or selling an asset without significantly affecting its price. High liquidity implies that there are many buyers and sellers actively trading, leading to narrower spreads.

• Time Horizon: Forward quotes involve the delivery of currencies at a specified future date, while spot quotes involve immediate exchange. The longer time horizon in forward contracts introduces uncertainty, which can widen bid-ask spreads compared to spot quotes.

• Interest Rates: Forward contracts consider interest rate differentials between the two currencies. These differentials impact the forward exchange rate and, consequently, the bid-ask spread. Changes in interest rates can cause variations in the spread for forward quotes.

• Market Sentiment: Market participants’ perceptions and expectations about future currency movements can influence bid-ask spreads differently for spot and forward quotes. Changes in market sentiment may cause discrepancies between the two spreads.