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Spreads: The Meaning in Trading Explained

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The spread is the difference between the bid and ask price of a currency, commodity, or index. We can also define it as the difference between a buying and selling price. Hence, it’s known as the brokers’ profit.

In one of the most common definitions, the spread is the gap between the bid and the ask prices of a security or asset, like a stock, bond, or commodity. This is known as a bid-ask spread. Spreads can also be constructed in financial markets between two or more bonds, stocks, or derivatives contracts, among others.

Understanding Spreads

Spreads can also refer to the difference in a trading position – the gap between a short position (that is, selling) in one futures contract or currency and a long position (that is, buying) in another. This is officially known as a spread trade.

In underwriting, the spread can mean the difference between the amount paid to the issuer of a security and the price paid by the investor for that security—that is, the cost an underwriter pays to buy an issue, compared to the price at which the underwriter sells it to the public.

In lending, the spread can also refer to the price a borrower pays above a benchmark yield to get a loan. If the prime interest rate is 3%, for example, and a borrower gets a mortgage charging a 5% rate, the spread is 2%.

The spread trade is also called the relative value trade. Spread trades are the act of purchasing one security and selling another related security as a unit. Usually, spread trades are done with options or futures contracts. These trades are executed to produce an overall net trade with a positive value called the spread.

Types of Spreads

Spreads are found in many financial markets and change based on the type of investment or financial product.

In markets where buyers and sellers interact, like stocks, there’s something called a bid-ask spread. This spread is the gap between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask). It helps to see how easy it is to trade a stock.

Forex trading also uses bid-ask spreads, which can change based on factors like how easy it is to trade a currency pair, market conditions, and the broker’s rules. Some brokers have fixed spreads, while others have variable ones that can change. Traders should know the spreads they’re offered because they affect how much they pay for a trade.

Interest Rate Spreads

A yield spread represents the variance between yields of different debt instruments, taking into account their varying maturities, credit ratings, issuers, or risk levels. It is computed by subtracting the yield of one instrument from another and is commonly expressed in basis points (bps) or percentage points. Yield spreads are frequently compared against U.S. Treasuries, referred to as the credit spread. Analysts often denote the yield spread as the “yield spread of X over Y,” indicating the annual percentage return on investment of one financial instrument minus that of another.

The option-adjusted spread (OAS) gauges the yield difference between a bond containing an embedded option, such as an MBS, and the yield on Treasuries. Unlike merely comparing a bond’s yield to maturity with a benchmark, the OAS offers a more precise evaluation. By dissecting the security into its bond component and embedded option, analysts can assess the investment’s viability at a given price. To align a security’s price with the prevailing market price, the yield spread must be incorporated into a benchmark yield curve. This adjusted price is referred to as the option-adjusted spread and is commonly used for mortgage-backed securities (MBS), bonds, interest rate derivatives, and options. For securities with cash flows independent of future interest rate movements, the option-adjusted spread aligns with the Z-spread.

The zero-volatility spread (Z-spread) is the constant spread that equates the price of a security with the present value of its cash flows, when added to the yield at each point on the spot rate Treasury curve where cash flow is received. It provides insight into the bond’s current value along with its cash flows at these points. Analysts and investors utilize the spread to identify discrepancies in a bond’s price. Also known as the yield curve spread and zero-volatility spread, the Z-spread is commonly used for mortgage-backed securities. It derives from zero-coupon treasury yield curves required for discounting a predetermined cash flow schedule to attain its current market price. This type of spread is also integral in credit default swaps (CDS) to measure credit spread.

Interest Rate Spread Example

Imagine an investor evaluating two bonds: one from Company XYZ offering a 5% yield, and the other, a Kenyan Treasury bond yielding 3%. The yield spread, which is the difference between the yields of the two bonds, stands at 2% (5% – 3%). Essentially, the corporate bond presents a 2% higher yield compared to the Kenya Treasury bond.

Should the investor perceive Company XYZ as financially stable with minimal default risk, they might opt to purchase the corporate bond while selling the Kenya Treasury bond, aiming to capitalize on the yield spread—a strategy commonly referred to as a “yield spread trade.”

If the investor’s analysis proves accurate and Company XYZ’s credit risk remains low, they stand to gain the 5% yield on the corporate bond and secure a profit from the 2% yield spread. However, if Company XYZ’s credit risk surpasses expectations and leads to bond default, the investor faces the possibility of losing their entire investment in the bond. Hence, it’s imperative for investors to meticulously assess the credit risk associated with any bond before engaging in a yield spread trade.

FAQs

How Do You Calculate a Spread in Finance?

In simple terms, a spread is the difference between two prices. For instance, a bid-ask spread is figured out by subtracting the bid price from the offer price. Similarly, in options trading, a spread is determined by the difference in the prices of one option compared to another.

Why Would Someone Buy a Spread?

Traders seek to capitalize on spreads by speculating whether the gap between prices will contract or expand in the future. When you purchase a spread, you anticipate that the difference between two prices will increase. For instance, if you predict that the interest rates on junk bonds will escalate more rapidly than those of Treasuries, you may opt to invest in that yield spread.

How Do You Put on a Spread in Trading?

To do a spread position in the markets, you usually buy one thing and sell another related thing at the same time. The spread price is the difference between what you pay and what you get from the sale.

Conclusion

In money stuff, a spread is when there’s a difference between two prices, rates, or how much money you get. One kind of spread is the bid-ask spread. That’s when the price buyers want to pay is different from the price sellers want to get for a thing like a stock or bond.

A spread can also be the difference between two trading positions. Like, if you’re selling one thing and buying another, that difference is called a spread trade.

Spreads can also talk about how much the people who give out a loan get compared to how much the borrower pays back. There are different types of spreads like yield spreads, option-adjusted spreads, and Z-spreads, which get used in different money situations.

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