What’s a Spread?
The spread is the difference between the bid price (the price you sell at) and the ask price (the price you buy at), quoted in pips. (A pip is 1/100 of one percent.) For example, if the quote between EUR/USD at a given moment is 1.4222/1.4223 (sell vs. buy, sometimes expressed as 1.4222/223), then the spread is 1 pip. If the quote is 1.4222/1.4242, then the spread is 20 pips.
The spread is also how banks and brokers make money. Wider spreads mean a higher ask price and a lower bid price. As a consequence, you pay more when you buy and get less when you sell, making it more expensive for you. The difficulty lies in knowing whether a wider spread is based on market conditions (that is, when there is less market liquidity during critical news events or non-trading hours), or if it’s simply based on extra profit for the bank or broker.
Banks and forex brokers typically don’t earn the full spread because they, in turn, must hedge out net client foreign currency exposure with other banks, which costs them the spread as well. The spread compensates forex brokers for taking on the risk that the price might change from the time they execute a client’s trade to the time they safely hedge their net exposure with a bank.
Banks make money by creating trading volume that results in natural trading offsets (situations where the banks are earning the full amount of the spread). Banks also make money by increasing the spread charged in excess of the interbank spread for forex trading.
How can you calculate bank spreads?
Bank spreads are difficult to determine because they’re often a combination of factors, which differ based on the transaction settlement date:
Forex Transactions Settled Immediately
For foreign currency transactions settled immediately, in addition to banking fees, the spreads may include:
- An interbank forex spread
- A bank commission built into the spreads
Forex Transactions Settled in the Future
For foreign currency transactions settled in the future, the spreads may include:
- An interbank forex spread
- An interest differential
- An interest differential risk premium
- A bank commission built into the spreads
The interest differential or interest carry cost is based on the deposit rate for the purchased currency and the lending rate for the sold currencies over the life of the hedged product. With longer forex hedge expiry dates, the interest differential will have a greater impact on the spread, and be more volatile. For transactions with expiry dates in the future, then, the challenge is determining how much of the spread is due to the interest differential cost as opposed to an extra commission for the bank.
