What is the Bid-Ask Spread in Foreign Exchange?
The bid-ask spread in an exchange of currencies is the difference between what a foreign currency dealer will buy and sell a particular currency for.
The bid price is what they are willing to pay for a currency and the asking price is what they are willing to sell a currency for.
If, for example, the bid-ask spread for EUR/GBP (euro/pound sterling) is advertised by a foreign currency dealer as 0.8452/0.8456 this means that they will buy 1 EUR for 0.8452 GBP and sell 1 euro for 0.8456 GBP.
If you were to sell this dealer 1,000,000 EUR, they would give you 845,200 GBP. However, it would cost 845,600 GBP to buy 1,000,000 EUR.
Why is There a Bid-Ask Spread?
Foreign currency dealers quote exchange rates with a bid-ask spread in order to cover their costs and make a profit.
In other financial services, it is common for dealers to charge a commission and this does sometimes happen in currency exchange. However, rather than charging a commission for exchanging currency, it is the convention for dealers to make their charges within the bid-ask spread.
The reason behind this is that it makes the process of calculating how much one currency will be worth in another simpler. Going back to our example, it is possible to see straight away that if you have 1,000,000 EUR, the dealer will pay 845,200 GBP for it. If there were a commission to calculate on top of the exchange rate, this would require an extra step and would add unnecessary complications to the calculation.
To get around this problem, dealers just set all of their exchange rates with a bid-ask spread. An upshot of this is that the dealer’s charges become hidden within the bid-ask spread. However, it is still simple to compare the exchange rates offered by different dealers and just pick the best one available.
How Do You Calculate the Bid-Ask Spread?
The bid-ask spread is normally expressed as a percentage and is calculated according to the following formula…
Going back to the earlier example, the foreign exchange spread can be calculated as
A simpler way of expressing the bid-ask spread is just by expressing it directly by subtracting the bid price from the asking price.
In our example, this would be 0.8456 – 0.8452 = 0.0004
Why Do Bid-Ask Spreads Vary?
Bid-ask spreads vary from currency to currency and from dealer to dealer. It is a good idea to understand the kind of rate that you should get for particular currency exchange and to shop around to find the best dealer.
Different dealers offer different rates. The example rates used so far, with a bid-ask spread of only 0.0473%, are minimal rates, with the dealer taking relatively little profit from the exchange of currencies. This might be the kind of rate that is available for a large international transaction.
Other dealers, however, do not offer such good rates. The rates that are available at airport kiosks offering currency exchange are a good example of poor rates of exchange. These dealers have a wider bid-ask spread because they charge a larger amount for currency exchange.
Airport Currency Exchange Kiosks
For example, an airport currency exchange service may offer rates for EUR/GBP of 0.8250/0.8750. At this rate, it would cost 8750 GBP to buy 10,000 EUR and 10,000 EUR would be worth 8250 GBP.
In this example, the bid-ask spread is 5.714% or equal to 500 GBP. This is a relatively large spread and represents a large fee being charged by the dealer.
It should be pointed out that different dealers offer different rates and they may actually be more favourable than this or alternative rates may be given for large amounts of money, such as 10,000 GBP, compared to smaller amounts of money. Airport kiosks also have significantly higher costs to cover and usually deal with small amounts of currency, which forces them to charge more.
However, it is common knowledge that airport currency exchange kiosks tend to charge a higher amount than other dealers. The convenience that they offer usually makes them a good choice for smaller exchanges of currency, such as for a small amount of holiday spending money.
The Amount of Currency
As we just mentioned, the amount of currency that is exchanged may affect the rate that is available. The same dealer may offer a more preferential rate to a customer who is looking to exchange a large amount of currency. Individuals who exchange a small amount, such as 250 GBP for the first few days of a holiday, usually pay far more than businesses or individuals who exchange large sums of money.
Currencies that are traded around the world in large volumes usually come with a lower fee and, as a result, with a lower bid-ask spread. This relates to market liquidity, which is also a fundamental aspect of bid-ask spreads in industries other than a currency exchange.
Where a dealer is able to buy a currency and quickly sell it to another buyer, the market is said to have a high level of liquidity. This is common in currencies that are traded in large volumes, such as pound sterling (GBP), US dollars (USD), and euros (EUR). Essentially, because it is easy for a dealer to find a buyer for a particular currency, they are able to trade with tighter margins, which are shown directly in tighter bid-ask spreads.
Currencies that are subject to a higher level of volatility usually come with a larger bid-ask spread because dealers look to protect themselves against the risk that they take by trading in them.
Whether it be due to political instability, economic instability, or other causes, certain countries have unstable currencies. The pound sterling has even had a notably higher level of instability since the Brexit vote of 2016.
Where this happens, currency dealers take a bigger risk when they obtain foreign currency for future exchanges. The risk that the currency could drastically alter in value is reflected in the bigger bid-ask spread in exchanges for this currency (which itself represents a larger fee is charged).
Fluctuating Exchange Rates
For people who frequently deal in exchange rates and track the movements of bid-ask spreads for different dealers, it quickly becomes obvious how much exchange rates vary over time.
While savings can be made by switching between different foreign currency dealers, many people find that even bigger savings can be made by chance when the exchange rate changes in a favourable way.
However, losses can be made as a result of fluctuating exchange rates as well and in business, this can be a particularly big problem.
It is estimated that, for small and medium-sized enterprises in the UK which deal in foreign currencies, the average annual loss as a result of fluctuations in the exchange rate is in the tens of thousands of pounds.
What many of these companies can do is carry out FX hedging. This is when businesses that are exposed to risk from fluctuating exchange rates provide themselves with an alternative to committing to making exchanges of currency in the future that will be done at whatever the current market exchange rate is at that time.
Bound are FX hedging specialists. Our online platform provides a fast, easy and transparent way for businesses that deal in foreign currencies to manage their currency exchanges over time in order to ensure that they don’t lose out as a result of changes to the exchange rate.
Some people are completely unaware that it is possible to fix an exchange rate for a foreign exchange transaction in advance. It is common practice for businesses to be able to fix their exchange rates for up to a year in advance and to operate with complete certainty about what costs and profits will be when operating internationally. On top of this, it is also possible in many cases for international businesses to both protect themselves against an unfavourable change in the exchange rate and benefit from a favourable one.