Bid-Offer Spreads and the Market Position

The spread (also called dealers spread or the bid-offer spread) is the difference between the bid price and offer price. This represents the market markers margin. In the case of prices from brokers, it is the difference between the highest bid and the cheapest offer. Most currencies are quoted with spreads of 3 to 5 pips.

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.

• 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.

• 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.