BID-ASK SPREAD

Definition

The bid-ask spread is the difference between the highest price a buyer is willing to pay for a security (bid price) and the lowest price a seller is willing to accept (ask price). It represents a transaction cost for traders and a key measure of market liquidity.

A narrower spread generally indicates a more liquid market, while a wider spread suggests lower liquidity or higher volatility.

Origins

• "Bid" comes from the Old English biddan (“to offer” or “request”).

• "Ask" (or “offer”) comes from the Old English ascian (“to seek” or “demand”).
  The concept of a spread became standardized with the growth of organized exchanges in the 19th and 20th centuries, especially in stock, bond, and foreign exchange markets.

Usage

• Equities – Spread reflects supply/demand for a stock.

• Bonds – Often wider for corporate or illiquid bonds.

• Forex – Spread varies by currency pair volatility.

• Commodities – Influences futures and spot pricing.

• Derivatives – Determines entry/exit efficiency in options and futures.

How Bid-Ask Spread Works

1. Bid Price – Maximum price buyers are willing to pay.

2. Ask Price – Minimum price sellers are willing to accept.

3. Spread – Ask price minus bid price; paid implicitly by traders.

4. Market Maker Role – Dealers quote both prices and profit from the spread.

    

Types of Bid-Ask Spreads

1. Quoted Spread

• Direct difference between bid and ask prices.

2. Effective Spread

• Based on the actual transaction price and midpoint.

3. Relative Spread

• Spread expressed as a percentage of the mid-price.

   

Key Takeaway

• Narrow spreads = high liquidity, competitive markets.

• Wide spreads = low liquidity, higher trading costs.

• Spread size depends on market conditions, volatility, and trade volume.

• Market makers and brokers earn revenue from spreads.

Context in Financial Modeling

• Liquidity modeling – Spread affects execution costs.

• Market impact analysis – Wider spreads reduce trading efficiency.

• High-frequency trading – Profitability depends on exploiting small spreads.

• Portfolio returns – Net returns reduced by transaction costs from spreads.
  
  

Nuances & Complexities

• Order size impact – Large trades may move prices, widening the spread.

• Volatility impact – Spreads widen during high uncertainty.

• Dealer inventory risk – Market makers adjust spreads based on holding risk.

• Different asset classes – FX spreads often in pips, equities in cents, bonds in yield points.
  
  

Mathematical Formulas

$$\text{Bid-Ask Spread} = \text{Ask Price} - \text{Bid Price}$$

Spread as Percentage of Ask:

$$\text{Spread (\%)} = \frac{\text{Ask Price} - \text{Bid Price}}{\text{Ask Price}} \times 100$$

$$\text{Overcollateralization Ratio} = \frac{\text{Collateral Value} - \text{Bond Value}}{\text{Bond Value}}$$

Related Terms

• Liquidity
  
  

• Market Maker
  
  

• Order Book
  
  

• Pip
  
  

• Slippage
  
  

• Transaction Costs

Real-World Applications

Example 1: Stock

• Bid = $50.00, Ask = $50.05 → Spread = $0.05

• As % of ask: (0.05 ÷ 50.05) × 100 ≈ 0.1%

Example 2: Forex

• EUR/USD bid = 1.1050, ask = 1.1052 → Spread = 2 pips.

Example 3: Corporate Bond

• Bid yield = 5.10%, ask yield = 5.20% → Spread = 10 bps.

References & Sources

• Accounting Insights: What Does Pips Mean and How Are They Calculated?