I’m having a hard time understanding the bid-offer spread.
I follow that the spread represents basically a brokerage fee that the counter party charges.
But how do you determine which to use when you’re pricing fowards based on a spot rate?
Your question’s too broad. Add more specifics… at this point you’re asking people to explain the entire section on pricing forwards :).
You are a very confused individual.
- Bid/offer is not a brokerage fee. It is just the difference between the lowest price that someone offers something and the highest price that someone will bid for it. For instance, let’s say we are shopping for a house. A particular house is for sale at $500,000. This is the “ask” price. However, I don’t want to pay that much - the most I want to pay is $480,000; this is the “bid” price. So, the inside market for this house is $480k/$500k. You can apply the same logic to stocks, bonds, or whatever.
Brokerage fee (commission) is the price that a broker would charge to make a market for you. It is different from bid/ask spread.
- When you price forwards, you use a different spread - this is called forward spread, or basis. It is the difference between the spot and forward prices.
If you have a specific context, that might help clarify what you are trying to ask.
+1
Ohai-
YOU are the “very confused indivudual”
The offer price is always higher than the bid price. The bid–offer spread—the difference between the offer price and the bid price—is the compensation that counterparties seek for providing foreign exchange to other market participants.
(Institute 486)
Institute, CFA. Level II 2013 Volume 1 Ethical and Professional Standards, Quantitative Methods, and Economics. John Wiley & Sons (P&T), 7/9/2012. .
Its this part that I’m not clear about. What I know as the Bid-Ask spread typically indicates liquidity in a market, based on the exerpt above, they don’t seem to be the same thing.
we got a bad ass over here
Everyone here is right. Ohai’s definition is correct if you look at quotes on the market, and pass hungry definition is correct from the perspective of someone making a market.
With regards to the original question, wouldn’t the rate you use be based on how you hedge the trade? FX stuff isn’t as intuititive to me, but if you look at market making options, you need considering the hedge instrument bid/offer prices when making a market (i.e. the price you are willing to buy a call will depend on the price you can sell the underlying, and vice versa). So presumably, if you make a market for FX forwards, wouldn’t the same logic apply (i.e. you buy an FX forward, you sell the spot, and vice versa).