Spread (Finance)

In finance, a spread is the difference between two related prices, interest rates or yields. The most common uses are the bid-ask spread, the gap between the price at which a dealer will buy and the price at which it will sell; the yield spread, the extra return one bond pays over another; and the lending spread, the margin a bank earns between what it charges borrowers and what it pays depositors. Spreads are usually quoted in basis points, where one basis point is one hundredth of a percentage point.

Spreads matter because they measure costs, risks and expectations that a single price cannot show. A narrow bid-ask spread signals a liquid market; a widening credit spread signals rising fear of default; and the gap between long and short government yields says something about expected growth and interest rates. The word is also used for option and futures strategies that combine two positions.

Think of a currency booth at an airport. It shows two prices for each currency: a lower one at which it will buy your leftover notes and a higher one at which it will sell you new ones. The gap between them is how the booth earns its living and covers the risk that rates move before it can pass the money on.

Every market has gaps like this. A bank pays savers less than it charges borrowers, and a company that might fail has to promise lenders more than a safe government does. Watching how wide or narrow these gaps are tells you how costly, risky or nervous a market is.

A market maker quotes a bid (the price it will pay) and an ask or offer (the price it will accept). The spread compensates it for processing costs, for holding inventory and for the risk of trading with better-informed counterparties. It is often expressed relative to the midpoint, or mid-market rate:

• $P_{\text{ask}}$ is the price at which the dealer sells.
• $P_{\text{bid}}$ is the price at which the dealer buys.

If a share is quoted at a bid of $99.90 and an ask of $100.10, the spread is $0.20 and the midpoint is $100, so the percentage spread is 0.2 percent. An investor who buys at the ask and sells straight back at the bid loses that amount. Spreads are tight in large shares and major currencies and wide in small or illiquid assets, which is why spreads are a standard measure of liquidity. In currency markets the equivalent is the FX spread, to which retail providers often add a markup.

A yield spread is the difference between the yields of two bonds:

Here $y_{1}$ and $y_{2}$ are the two yields written as decimals. If a five-year corporate bond yields 5.5 percent (0.055) and a five-year US Treasury note yields 4.2 percent (0.042), the spread is $0.013 \times 10{,}000 = 130$ basis points. That extra yield is a risk premium for default risk and lower liquidity, and it is larger for bonds with a lower credit rating, such as high-yield bonds.

The same idea applies to countries. The gap between a government's borrowing costs and those of a benchmark issuer, such as German Bunds in the euro area or US Treasuries for dollar debt of emerging markets, is a common gauge of sovereign risk. The term spread between long- and short-dated government bonds describes the slope of the yield curve; when it turns negative the curve is inverted, which has often preceded US recessions.

• Lending spread. The difference between a bank's loan and deposit rates; across the whole balance sheet it appears as net interest margin, the main source of income for a commercial bank.
• Underwriting spread. The discount between the price investors pay for new securities and the amount the issuer receives, which is the fee earned by an investment bank for underwriting.
• Swap spread. The gap between the fixed rate on an interest rate swap and the yield on a government bond of the same maturity; see swap.
• Option and futures spreads. Strategies that buy one contract and sell another, such as a bull call spread in options or a calendar spread in futures, to limit risk or bet on a price difference.
• Commodity spreads. Processing margins such as the crack spread between crude oil and refined products, or the spark spread between gas and electricity prices.

Central banks, investors and regulators track spreads as early-warning indicators. Sharp widening in corporate, interbank or sovereign spreads marked the 2008 financial crisis and the euro-area debt crisis, and monetary policy tools such as asset purchases have been aimed partly at compressing them. Spreads can also mislead: they can stay unusually narrow when investors are complacent, and they mix several factors, such as default risk, liquidity and supply, that are hard to separate. Analysts therefore compare spreads with their own history and with other signals rather than read them in isolation; differences in quoted prices across markets also create opportunities for arbitrage.

• Investor.gov: Bid-Ask Spread
• TreasuryDirect (US Department of the Treasury)