Question

Explain how banks/foreign exchange dealers make money off the bid-ask spread, and why you can have two rate quotes on any currency.

Answer 1

Banks and foreign exchnage dealers make profit from the spreads between bid and ask rate.

Bid ask spread is the difference between the selling price (ask price) and the purchasing price ( bid price) of a security. Ask price is a price at which seller is ready to sell and bid price is the price at which buyer is ready to buy. Bid ask spread trades can be done in all kinds of securities such as forex, commodities and intrest rate yields. The bid is always lower than the ask price and the spread is the difference between them, in case of the normal markets.

Dealers makes money in every situation of the market. It can make profit in any situation. He earna profit mainly from volatility and spread management.

Dealers has to set the bid and ask price by:

1. Dealers makes money by looking at the demand versus supply.

2. Dealer has to consider quotes from other dealers to set the price in line with the market.

3. Dealers considers a tight spread, if the spread is too wide, then there will be case of lossing orders.

4. Dealer can build up losses easily in the case of narrow spread.

5. In case of riskier situation, dealer takes a higher spread which makes trading expensive for price takers .

6. Dealer increase the spread to offset the risk.

7. For money making, dealers considers fundamental as well as technical indicators that gives signals when to buy or sell and also allows to make profit in times of high risky situation.

Bid ask spreads are used to cover trading costs.