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Factors That Determine the Width of a Bid & Ask Spread in Foreign Currency

Original post by Michael Wolfe of Demand Media

One of the challenges faced by foreign exchange or "forex" traders -- investors who trade foreign currency -- is finding a buyer or seller for their currencies at the right price. Sometimes, a considerable gap will exist between a currency's bid price (the price that buyers are willing to pay) and the ask price (the price that sellers on the market are asking).

Bid Price

The bid price is the price that the prospective buyers of a particular currency are bidding to purchase it. Because foreign currencies are always denominated in other currencies, the bid price is provided as a relationship. For example, a buyer may bid two Euros for one U.S. dollar. The bid price represents not the actions of one bidder but the sentiment of an entire market, although currencies are not traded on a single centralized exchange.

Ask Price

The ask price is the price that a seller is asking for a particular currency. As with bid prices, the seller offers his ask price in terms of a relationship with other currencies. In addition, because currencies are not traded on a centralized exchange with price transparency, a gap may exist between what the seller wants and what the buyer is willing to pay.

Liquidity

The biggest reason for a gap between the bid and ask price for a foreign currency is a mismatch between supply and demand in illiquid markets. This is particularly true in markets for smaller currencies, which are not as liquid as more heavily traded currencies, such as the U.S. dollar and the Euro. Currencies with many buyers and sellers usually have a minimal spread, while fewer players generally translate into larger gaps.

Discrepancies in Information

A large spread may also signal a discrepancy in information between the buyer and seller. Centralized exchanges provide forums in which data on price and other factors affecting the value of a stock or commodity are the open, whereas with a currency trade, the seller and buyer may have different information about its worth and different expectations about the price they can fetch for it.

                   

References

  • "Investing For Dummies"; Eric Tyson; 2008

About the Author

Michael Wolfe has been writing and editing since 2005, with a background including both business and creative writing. He has worked as a reporter for a community newspaper in New York City and a federal policy newsletter in Washington, D.C. Wolfe holds a B.A. in art history and is a resident of Brooklyn, N.Y.

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