Bid/Ask Spread Essay ⋆ Business Essay Examples ⋆ EssayEmpire

The bid/ask spread is also known as the bid/offer spread. In the financial markets the bid price is the price at which a dealer (market-maker) will buy a particular security from an investor. The ask price is the price at which the dealer will sell that security to an investor. The difference between these prices is the spread. This bid/ask spread represents the profit margin for the dealer who trades in a security after allowing for any carrying cost that may be involved if the market is not liquid.

In liquid markets (continual buying and selling) where there are always buyers for the security and trades are quickly concluded, carrying costs will be negligible. However, for some securities it may take a dealer some time to find a buyer and the carrying cost will be the interest earnings foregone by the dealer by tying up money in holding the security. As a general rule, the bid/ask spread for a liquid security, such as shares in a blue-chip company, will be narrower than the spread for a share in a start-up company. In the latter case the spread between bid and ask prices will be wider to compensate for the additional time the dealer will be tying up money in holding the security.

Bid/ask spreads are customary in all financial markets, including shares, bonds, mutual funds, and currencies. The narrowest spreads are found in the currency markets, which are the most liquid. The spreads here will be measured in basis points (hundredths of a percent), whereas the spread for an illiquid company share may be measured in full percentage points of the asset’s value.

In addition to volume of trade (liquidity), the spread for a security will be determined by the volatility of the asset’s price and also the volatility of the market in general. At times of market volatility all bid/ask spreads will widen. Individual securities with a history of sharp price changes will also have a wider spread than securities with more stable price characteristics. In the stock market the bid/ask spreads for low-priced shares may be wider than for higher priced shares. The low price may be an indicator of illiquidity in the market for that share. The share prices quoted in newspapers are usually the midpoint of the spread at the previous close of business. For the investor wishing to calculate the return on a security, it is important to ensure that performance is based on an ask-to-bid basis.

A perfectly reversible security would allow the investor to move from cash into the security and back again without loss of value. Any security with a bid/ask spread is, therefore, imperfectly reversible. The market makers are responsible for maintaining an orderly market by providing continuous buying and selling prices. This can only be done by holding inventories of the securities, which requires the market makers to tie up capital. The bid/ask spread is their means of compensation for this essential activity. In open and competitive markets there may be variations in the bid/ask spreads from dealer to dealer for particular securities, but arbitrage will ensure they converge. With an exchange-traded security the client may get a better price than the indicated bid/ask spread as the dealers may improve the transaction price within the spread. With over-the-counter (OTC) deals the client will only deal at the quoted spread.

Bid/ask spreads are not only found in spot markets (immediate trade) but also in forward markets. Thus a bank may quote a bid/ask spread on forward exchange rates. Once again this spread will be wider for currencies that are more difficult to trade. Tourists are familiar with an everyday example of the bid/ask spread when they buy currency for foreign travel. Banks and bureaux de change quote two prices depending on whether the tourist is buying or selling the foreign currency. The difference represents the profit to the dealer. As a general rule in any transaction the dealer gets the more attractive price and the investor/purchaser the less attractive price. The bid/ask spread is a valuable source of information for investment planning, providing insight into the liquidity and potential volatility of a security.

Bibliography:

Alexander and E. Sheedy, The Professional Risk Manager’s Guide to Financial Markets (McGrawHill, 2006);
Connolly, The UK Trader’s Bible (Harriman House, 2007);
Vaitilingam, The Financial Times Guide to Using the Financial Pages (Prentice Hall, 2006).

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