The spread represents an opportunity for the market marker to make a profit, provided the exchange rates do not move. For example, suppose that a dealer buys USD 1 million from a customer in exchange for Singapore Dollars at a USD/SGD rate of 1.5725, and then immediately sells the dollars to another customer at a rate of 1.5730. The cash flows on the value will be:
| Bank Receives: | USD 1,000,000 | |
| Bank Pays: | | SGD 1,572,500 |
| Bank Pays: | USD 1,000,000 | |
| Bank Receives: | | SGD 1,573,000 |
| Balance: | NIL | SGD 500 |
The dealer has made a profit of SGD500 (or 5 points on USD 1 million at SGD100 per point per million dollars) and has a square or flat in dollars.
There is of course no guarantee that the dealer will be able to make this profit, as market rates are constantly changing. However, the wider the spread quoted, the greater the likelihood of closing the position at profit.
The dealer’s spread is compensation for the risk he takes when making a market, and for the costs of providing the service to customers. The size of the spread will be related to the amount of risk attached to any given deal.
Positions
Banks that deal in FX are said to have a long, short or square position in each currency they trade.
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A long position is a market position where the bank has bought a currency in excess of immediate requirements, normally with a view to selling it later at a profit.
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A short position is a market position where the bank has sold currency that it does not own, normally with a view to buying it later, when required (i.e sales of the currency exceed purchases). If the banks short position is speculative, it is is expecting the currency’s value to fall.
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A square or flat position exists when the bank is neither long nor short in currency.
Market Volatility and the Bid-Offer Spread
If the exchange rate of a particular currency pair is volatile, i.e. normally moves rapidly and erratically, and large changes are common then there is a greater risk that the dealer will be unable to cover his position at a profit. He will therefore widen the spread so that a larger movement must take place before he is in a loss-making position.
Market Liquidity and the Bid-Offer Spread
In a highly liquid market such as USD/EUR, USD/JPY or GBP/USD, a dealer can cover his position quickly, with one of a larger number of counterparties and without his, activity having an impact on the exchange rate. His risk is therefore less, and a narrower spread can be quoted. The normal spread for interbank deals in major currencies is 3 to 5 points.
In illiquid markets, there is a risk that some time may be taken to execute a deal and that the deal itself will adversely affect the market price. Spreads therefore tend to be considerably wider.
