Foreign Exchange Quotations: Bid-Ask Spread
12.1: Introduction
The spot quotations discussed in Session 11, were given as one rate i.e,
USD/INR 42.75. However, in real life, like any market place, buyers and sellers
give their buying and selling rate. Hence at a given point of time, there are
two rates available.These two rates are known as “bid” and “ask” rates.
As discussed in Session 4 (market
participants in foreign exchange market), forex dealers give both bid rates and
ask rates. Bid-ask rates are given
by forex dealers who are willing to buy and sell forex at these rates. It is to
be noted here that in a traditional market, the buyers and sellers are normally
separate entities. For example, buyers and sellers of steel would be different.
A buyer is an user of the steel while seller is the producer of the steel.
However in a forex market buyers and sellers can be individual entities
(exporters or importers) as well as a single entity buying and selling a
currency simultaneously. The difference between these two rates is known as bid-ask spread.
Different aspect of bid and ask rates
are discussed in the session i.e, what is bid-ask rates, how banks use the
bid-ask rates to change the inventory of the currency they hold, how bid-ask
price in Indian spot market has changed significantly over the years and how
demand and supply of a currency impacts the bid-ask spread.
12.2: Bid-Ask Rates:
Suppose State Bank of
India (SBI), a dealer in forex, is quoting bid-ask EURO/INR of 76.5025 to
76.5048 for spot transaction at 11.15am on 29th
August 20XX
In
this quotation, Euro is the base currency while INR is variable/term/quote
currency.
Bid-ask price is always expressed in
terms of base currency.
The bid rate indicates that, SBI is
willing to buy 1 Euro from the counterparty and pay INR 76.5025. The ask rate
indicates that SBI is willing to sell (or give) 1 Euro to counterparty and
accept (or receive) INR 76.5048. In other words, for every Euro SBI buys and
sells, it makes a profit of INR 0.0013. Bid rate is always lesser than ask
rate.
While buying a currency, the traders
pay a higher amount compared to selling the same amount of the currency. The
bid-ask spread is what the bank/foreign exchange dealer profits.
The following website (http://www.hifx.co.uk/marketwatch.aspx) gives the interbank forex rate on a
real time basis. Table 12.2 shows a
snapshot of the interbank quotation. In fact Table 12.2 is just an extension to Table 12.1. Let us understand, bid-ask concepts discussed in this
section, in relation to the details given in Table 12.2.
The quotations are for spot rates.
While publishing quotations in any screen or over phone banks quote the base currency
first. In “GBPUSD” the GBP is the base currency and USD is the
variable/quote/term currency. Similarly, in “GBPAUD”, GBP is the base currency
while AUD is the variable/quote/term currency.
The bid and ask rates are from the bank’s
perspective. In the first row given in Table
12.2, at a bid price of “1.62536”, the bank would buy 1 unit of base currency
and sell 1.62536 units of
variable/quote/term currency. In other words, the bank will buy 1 GBP and pays
1.62536 of USD. At an “ask price” of
1.62576, the bank is willing sell/offer 1 GBP and receive 1.62576 of USD.
If a company wants to sell 1mn GBP (the
bank should buy 1mn GBP) and receive USD, then the company would pay 1mn GBP to
bank and receive USD162536. If the company wants buy 1mn GBP (the bank to sell
GBP), the company would pay USD162576. Bid–
Ask spread determines the profit for
the bank. It is very important to understand at this point is, bid price is always lesser than ask price.
Now if a company wants to buy or sell
USD (as base currency), then which rates it would be able to do so. The bid-ask
rate of 1.62536-162576 will not be directly applicable. The rate needs to be
converted so that USD becomes the base currency and GBP becomes the
variable/quote/term currency. If we merely reverse the rates i.e, (1/1.62536)
and (1/1.62576), we get a bid-ask spread of (0.61524 - 0.61509).
Table 12.3 Interbank Forex Quotations
However, this is not feasible as the bid
price > ask price. Hence the correct bid-ask spread is 0.61509 -
0.61524. The correct bid rate is (1/ask rate) and ask rate is (1/bid rate).
Both the correct and wrong bid ask spread for USDGBP quotation is given in Table
6.3.
With a bid-ask rate of 0.61509 -
0.61524, indicates that a company intending to buy 1mn USD, would pay GBP 61524
to the bank. A company intending to sell 1mn USD would receive GBP 61509 from
the bank. The bank quoting the above rate is making a profit of GBP 15 for
every 1 mn USD it buys and sells. Bid-ask
spread represent the profit potential
for the forex dealer while it the transaction cost for the company intending to
buy/sell forex. Of course, the spread must cover other costs such as phone
bills, internet charges, employees’
salary and bookkeeping charges etc.
In fact, the same figures can be
derived from Table 12.2. A company
intending to sell 1mn USD, has to pay USD1.62576 and receive 1 GBP. If the
company sells 1mn USD, he would receive GBP 615096. In fact the details given
in Table 12.3 are not necessary to
be calculated. It is given merely to understand the nuances of bid and ask
spread.
Table
12.4 shows
the restated bid and asks spread for the quotations given in Table 12.2. In Table 12.4, the base
currencies have been reversed.
Table 12.4 Restated forex quotations as given
in Table 12.2
To summarize, a trader need to first identify the base currency in a currency quotations. Then focus on the bid-ask rate
to determine the price he would pay/receive for any forex transaction.
One important aspect which needs to be
highlighted here is that the rates expressed in Table 12.2 and Table 12.3 are interbank rates. Interbank rates are
the rates offered by forex dealers
to each other. These rates are applicable to big-ticket players. However, if a
small or medium sized corporate or an individual would like to buy or sell GBP,
the bid-ask spread would widen. The following table, Table 12.5 details the rates a forex dealer may quote for
interbank, corporate and retail trades.
Table 12.5 Interbank and Retail forex Quotations
Now let us focus little more on the
bid-ask spread. It indicates the profit a bank/forex dealer would get if it
simultaneously buys and sells 1 unit of base currency. For example, the first
row in Table 12.5 indicates that a
bank would earn a profit of USD 0.00040 per every 1 unit of GBP it buys and
sells.
At
times bid-ask spread is quoted in
percentage terms. A banks/forex dealer’s spread
is calculated as
follows: spread = ask − bid *100 . bid
For
example, for the retail quotations given in Table 6.5, the spread is
spread =
1.62681
−1.62522
*100 =
0.071% 1.62522
The bid-ask spread occupies a very
important role in judging the liquidity in foreign exchange market. Better the
liquidity, lesser the spread. In India, the foreign exchange market has evolved
in a major way since last 10 years, after the introduction of FEMA 2000. The
RBI report on “Foreign Exchange Turnover” published in October 2010 shows the
changing bid-ask spread in the spot market. As per the RBI document “The
normal
spot market quote has a spread of 0.25 paisa to 1 paise while swap quotes are
available at 1 to 2 paise spread. A closer look at the bid-ask spread in the
rupee-US dollar spot market reveals that during the initial phase of market
development (i.e., till the mid 1990s), the spread was high and volatile due to
thin market with unidirectional behavior of market participants (Chart 3.3). In
the later period, with relatively deep and liquid markets, bid-ask spread has
sharply declined and has remained low and stable, reflecting efficiency gains”.
Figure 12.1:
Bid-Ask Spread in Spot Foreign Exchange Market
Forex exchange dealers not only provide
bid-ask quotations for spot trading, they also give bid-ask quotations for
longer duration forwards quotations. Forwards quotations bid-ask spread is
discussed in later sections.
12.3: Bid-Ask Spread and Demand Supply of
Forex dealers or banks from time to
time expand or squeeze the bid-ask
spread to manage the inventory
position in a given currency. Normally forex dealers or banks make these quotes for a currency pair
or some currency pairs. They are ready to buy and sell currencies at the quoted
rate. For example, if a dealer is quoting 1.62536-1.63576 for GBPUSD, then the
bank is willing to buy 1 GBP and pay USD1.62536 and willing to sell 1 GBP and
receive USD1.62576.
If a bank has more USD than it wants to
hold, then the bank offers a higher bid price. For example the bank may quote
USD1.63540 as bid price (instead of 1.62536). This means that the bank is
willing to buy 1 Euro and give USD1.62540 compared to USD 1.62536. This would
encourage many traders to sell Euro to the bank and in return receive higher
USD.
To reduce USD inventory, the bank may
also increase the offer price. Instead of 1.62576, the bank may offer, 1.62579.
This means that the bank requires the traders to pay USD 1.62579 instead of
earlier payment of USD1.62576. This would dissuade the traders to sell USD to
this bank.
Table 12.6 Change in Quotations ( GBP USD
rate) when a bank wants a change in inventory position of a currency
In a similar token, if the bank wants
to hold less Euro, it would like to buy fewer euros and also sell more Euro. To
achieve this, the bank would reduce the bid price as well as ask price. Table 12.6 highlights how banks would
narrow/widen bid-ask spread to manage currency inventory.
Hence, depending on their inventory
position, foreign exchange dealers/banks may narrow or widen the spread.
However, they are not absolutely free to quote any rate. Willy-nilly they have
to maintain parity with other dealers for the same currency pair. Too much of
difference in quotes among banks/dealers will lead to arbitrage profit i.e, thus forcing the rates to remain range bound.
When we compare the first two columns
of Table 12.6, it can be seen that
with the new rates, the bid-ask spread has reduced for the forex dealer/bank.
However, this is normally not the case. If a forex dealer/bank wants to reduce
the USD inventory, they would not like to change the bid-ask spread but only
shift the bid-ask midpoint. Table12.7
lists the bid-ask midpoint for the details given in Table 12.6.
Table 12.7:
Shifting of Bid-ask midpoint without changing the bid-ask spread.
Bid
|
Ask
|
Bid-ask Spread
|
Mid Point
|
|
GBPUSD
|
1.62536
|
1.62576
|
USD
|
1.62556
|
0.00040/GBP
|
||||
Reduce USD
|
1.62540
|
1.62578
|
USD
|
1.62559
|
inventory
(old)
|
0.00038/GBP
|
|||
Reduce USD
|
1.62541
|
1.62581
|
USD
|
1.62561
|
inventory (new)
|
0.00040/GBP
|
Midpoint
is calculated as midpo
int bid rate
2
Details given in second row of Table 12.7 shows that not only the bid
and ask rates have changed but the spread has reduced. However, forex dealers
will only change the bid and ask rates without changing the spread. The, third
row indicates that the bid-ask rate has
shifted to right without any change in
bid-ask spread. The midpoint has changed from 1.62556 to 1.62561. As per
the details given in third row, to reduce USD inventory, the bank would buy 1 GBP and pay USD 1.62541. It would sell and 1
GBP and receive USD1.62581.
The
bid-ask spread is also affected by large number of other factors. These are
•
Liquidity/trading volume in the market
•
Size of the transaction
•
Number of players, time of the day etc
•
Currency rate volatility.
In the United States, spreads tend to
be narrowest in the New York morning-Europe afternoon period, when the biggest
markets are open and activity is heaviest. Bid-ask spread is widest in the late
New York afternoon, when European and most large Asian markets are closed.
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