SPREAD

Definition

In finance, a spread refers to the difference between two related prices, rates, or yields. It is one of the most versatile concepts in financial markets, commonly used to describe:

• The bid-ask spread in trading (difference between buying and selling prices).
• The yield spread in fixed income (difference between two bonds’ yields).
• The credit spread (difference in yields between corporate and government bonds).
• The spread in derivatives trading (difference between strike prices or premiums).

Spreads reflect liquidity, risk, and market conditions.

Origins

The word "spread" originates from the Old English term sprǣdan, meaning "to stretch out" or "to extend." This etymology aptly describes the "gap" or "difference" that the term represents in finance. Its application in financial markets became more widespread with the development of modern trading and banking practices.

Usage

• Equities/FX – Bid-ask spread determines transaction cost.

• Bonds – Yield spreads indicate relative credit risk.

• Derivatives – Options spreads are trading strategies using multiple strikes/expiries.

• Commodities – Calendar spreads capture differences between near-term and future contracts.

• Banking – Net interest spread = lending rate minus deposit rate.
  
  

How Spreads Works

1. Identify the two prices/yields being compared.

2. Calculate the difference.

3. Interpret in context – A wider spread usually implies higher risk or lower liquidity, while a narrower spread implies higher liquidity or lower risk premium.
   
   

Types of Lot Sizes

1. Bid-Ask Spread – Transaction cost for trading securities.

2. Yield Spread – Difference in yields across bonds.

3. Credit Spread – Extra yield demanded for risky bonds.

4. Option Spreads – Multi-leg strategies (e.g., bull spread, bear spread).

5. Calendar Spread – Futures contracts with different maturities.

6. Z-Spread – Yield spread accounting for embedded options.

7. Swap Spread – Difference between swap rate and government bond yield
   
   

Key Takeaway

• Spread = measure of difference between two financial values.

• Reflects liquidity, creditworthiness, risk, and market conditions.

• Narrow spreads = high liquidity / low risk; wide spreads = low liquidity / higher risk.

• Central concept in trading, investing, and risk management.

Context in Financial Modeling

• Bond Valuation – Spread over Treasuries reflects default probability.

• Options Trading – Spread strategies model risk-return trade-offs.

• Bank Profitability – Net interest margin (spread between loan and deposit rates).

• Stress Testing – Widening credit spreads used in systemic risk analysis.
  
  

Nuances & Complexities

• Dynamic nature – Spreads tighten or widen with market cycles.

• Liquidity effect – Thinly traded assets have wider spreads.

• Credit conditions – Spreads are early-warning signals for defaults.

• Embedded risks – Some spreads (e.g., Z-spread) adjust for optionality.
  
  

Mathematical Formulas

Bid-Ask Spread

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

Yield Spread

$$\text{Spread} = Y_a - Y_b$$

Where $Y_a$ and $Y_b$ = yields of two different securities.

Credit Spread

$$\text{Credit Spread} = Y_{\text{corporate bond}} - Y_{\text{risk-free bond}}$$

Related Terms

• Bid-Ask Spread

• Credit Risk

• Yield Curve

• Liquidity

• Option Strategy

• Z-Spread
  
  

Real-World Applications

Bid-Ask Spread in Stocks – Apple stock: bid = $150.00, ask = $150.05 → spread = $0.05.

Credit Spread – 10-year U.S. Treasury yield = 3%, BBB corporate bond yield = 6% → spread = 3%.

Options Bull Call Spread – Buy call at $100, sell call at $110; payoff depends on spread between strike prices.

Banking Spread – Bank lends at 6%, pays 2% on deposits → spread = 4%. 

References & Sources

• Capital: What is Spread: Definition, Meaning & How It Works