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What is a bid ask spread

what is a bid ask spread
  1. Market-makers (which you term dealers) earn the bid-ask spread by buying and selling in as short a window as possible, hopefully before the prices have moved too much. It is not riskless. The spread is actually compensation for this risk. From The Race to Zero :

The market-maker faces two types of problem. One is an inventory-management problem – how much stock to hold and at what price to buy and sell. The market-maker earns a bid-ask spread in return for solving this problem since they bear the risk that their inventory loses value.

Market-makers face a second, information-management problem. This arises from the possibility of trading with someone better informed about true prices than themselves – an adverse selection risk. Again, the market-maker earns a bid-ask spread to protect against this

informational risk.

The bid-ask spread, then, is the market-makers’ insurance premium. It provides protection against risks from a depreciating or mis-priced inventory. As such, it also proxies the “liquidity” of the market – that is, its ability to absorb buy and sell orders and execute them without an impact on price. A wider bid-ask spread implies greater risk in the sense of the market’s ability to absorb volume without affecting prices.
  • The less liquid an asset is, the more time is likely to pass (and hence more information likely to arrive) until someone comes along to take the inventory from the dealer, and the greater is the risk that the price will have changed in the mean time. Since spread is compensation for this risk, ceteris paribus spreads are wider for less liquid assets.
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    Category: Forex

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