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SPOT FOREIGN EXCHANGE RATE QUOTATIONS AND SPREADS
1.0 Understanding Spot Foreign Exchange Rate Quotations
1.1 Definition and Importance of Spot Rates
Currency spot rates or the exchange rates for the currencies in the international markets for the
business of crossing the sale of currencies are the most integrant of the spot market. They set a
benchmark for setting the price for converting one currency to the other and play an important role in
assessing the value of goods, services and financial assets which are expressed on different currencies.
Further, the discussion of spot rates does not end here since through the use of forward rates calculated
from them, investors are able to manage currency risks. Forward exchange rate calculated from the spot
rates by adding the interest rate differential provides the businesses a way to hedge against future
transactions through the use of the forward rates (Madura, 2019). Also, spot rates bear the
consideration of a vast array of factors such as interest rate, inflation, political stability, and economic
performance (Madura, 2019). Anticipated by central monetary authorities through their monetary policy
measures which through setting of interest rates influence the spot rates to address factors such as
inflation and boost the economy’s growth (Madura, 2019). Also, spot rates indicates the balance point
of supply and demand of a particular currency in the forex market at a given period (Sarin, 2019). The
general demand for a currency against its availability in the market, pushes it’s spot rate up if the
demand is high relative to the supply in the market and it conversely devalues if the supply is high in
relation to demand (Madura, 2019). Spot rates are useful in scenarios to determine market and
economical fluctuations as well as their realities. If the foreign exchange is strongly touching the home
currency, this may be an implication of investors’ confidence in the country of residence while a
depreciating exchange currency may depict apprehension or adverse economic conditions (Madura,
2019). That is why individuals operating in the financial market pay particular attention to spot rates and
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use them as an indicator of general market trends and possible changes in factors that can influence
supply and demand (Madura, 2019). As such, spot rates are not only a measure of the exchange value of
foreign currency but they also contribute as market tools and fundamental data of exchange rate
markets and the general health of the economies involved.
1.2 Direct and Indirect Quotation Conventions
Direct and indirect quotation conventions are two crucial approaches to convey exchange rates as
stated by Carretta, Talevi, and Conteduca (2020). In direct quotation, some key features of the domestic
currency, including its value in terms of the amount of foreign currency, are conveniently captured, and
this makes for a simple presentation of the exchange rate (Carretta et al. , 2020). For instance when we
are quoting the direct rate of the EUR/USD exchange rate, it should be in the format of 1. 20, it means
that 1 euro equals 1 s messenger day and in 2017, the rate was one euro for one s messenger day. 20 US
dollars. On the other hand, indirect quotation expresses the foreign exchange against a fixed quantity of
the home country currency and gives an opposite glance to the exchange rate (Carretta et al. , 2020). In
the same context, let us explain it in an example; if the exchange rate for EUR/ USD is indirectly quoted
then it is 0. 83, it indicates that the exchange rate of the United States dollar for Ponzi is at par,
therefore 1 US dollar is equivalent to 0. 83 euros. The decision on which conventions to follow when
quoting directly or indirectly depends on historical practises in specific locations, legal basic guidelines,
as well as the needs and preferences of the market players (Carretta et al. , 2020). Direct quotation is
considered to be the most used quotation framework in most geographic locations, mainly in Europe
while, Indirect quotation is used occasionally in some geographic locations such as the United States
especially when quoting specific currency pairs (Carretta et al. , 2020). Considering these quotation
conventions is essential for a better understanding of quotations in foreign exchange rates and efficient
transactions in foreign exchanges markets (Carretta et al. , 2020). Recognizing these conventions
facilitates the relation between currencies’ identification when entering the market apart from that the
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identification of the relation makes the market participant consider the possible effect of changing the
exchange rates on the current transactions (Madura, 2019). Furthermore, mastery of other aspects of
quotation improves communication efficiency and enables compliance with current best practice in
quotation of financial instruments in international operations, thus minimising misunderstandings and
errors (Carretta et al. , 2020).
1.3 Major Currency Pairs and Market Conventions
The most traded pairs of currencies are commonly known as the Majors and these include the EUR/USD
pair,USD/JPY and the GBP/USD (Carretta et al. , 2020). These currency pairs are populated and very
liquid with high trading volumes, which makes them popular among traders and investors who wish to
minimize transaction costs by enjoying efficiency in the market (Carretta et al. , 2020). According to
market conventions, the major currency pairs are currencies quoted against the USD as either the base
or the quote currency because the US Dollar is the most established currency in world trade and
financial markets (Carretta et al. , 2020). For instance, in EUR/USD pair, EUR acts as the base currency
while USD being the quote currency that shows how much the base currency (euro, in this case) is worth
in the quote currency (USD; Carretta et al. , 2020). On the other hand, the USD/JPY or US dollar Japan
yen pair show the US dollar as the base currency and the Japanese Yen as the quote currency, indicating
the value equivalent of one US dollar in terms of the Japanese yen (Carretta et al. , 2020). It is crucial for
market actors to recognize critical foreign exchange pairs and their basic characteristics to operate in Fx
smoothly and hedge exchange risk adequately (Carretta et al. , 2020). Major currency pairs are known
for exhibiting different characteristics in terms of trends, volatility, and volatility patterns; therefore,
identifying these key qualities helps the trader approach the market effectively in terms of timing of
entry, sizing the position, and protection against risks (Madura, 2019). Furthermore, the understanding
of major currency pairs is helpful for determining and managing currency risks in cross-border
commercial transactions for businesses (Madura, 2019). Therefore, mastery of major currency pairs acts
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as a contingency tool that aids traders in making effective use of opportunities on the forex market in an
environment where currency risk significantly impacts the achievement of different financial goals on a
global level.
1.4 Sources of Spot Rate Quotations
Information on spot rate quotations needed in currency transactions is derived from various sources,
preferably from interbank markets, financial newspapers and electronic trading systems (Carretta et al. ,
2020). Interbank markets where banks and other institutes trade foreign currencies directly are of
pivotal importance for getting accurate and REAL TIME spot rate quotations (Carretta et al. , 2020). For
this reason, spot rates that are calculated from interbank markets are regarded as accurate and
indicative of market trends because the market makers as well as the participants are directly involved.
However, it shall be noted that the dissemination of spot rates is not reserved for inter-bank markets
alone, the financial media houses together with electronic trading platforms provide relevant
information regarding the particular spot rates to the concerned market players (Carretta et al. , 2020).
While business channels which include financial news channels collect and relay spot rates for use by
the public, the live trading platforms make real-time spot rate quotations available to the traders and
the investors (Carretta et al. , 2020). However, it should be remembered that very small differences in
spot rate quotations can sometimes be observed depending on the sources of information used, their
method of compilation, updates, and their frequency and financial or liquidity situation (Carretta et al. ,
2020). However, quotations for the spot rates are critical for the market participants to make the best
decisions and undertake proper transaction in the global Fx market (Carretta et al. , 2020). Thus, the
available spot rate data from reliable sources can help traders, investors, and business use simple
mechanized models to determine the market trends, trading opportunities, the potentiality of overseas
business ventures and the possibility of exposure to currency risks. Therefore, disseminating of multiple
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and reliable sources of spot rate quotations helps in attaining market clarity and order to flow, and
execution of operations across the global currency markets.
2.0 Factors Influencing Spot Exchange Rate Spreads
2.1 Market Liquidity and Trading Volume
Foreign exchange market liquidity, referring to the extent to which assets, instruments or securities can
be traded within a market without causing the price to fluctuate a lot is an important factor in forex
trading, (Chaboud et al. , 2014). High levels of liquidity mean that the cost of exchange is low, the bid-
ask spreads are narrow which allows for easy entry and exit in trading portfolios (Chakrabarty & Li,
2019). Liquidity levels and dynamics depend on a range of indicators like the number of players, depth,
and speed of matching in trading books of exchanges. Also, there is the attractiveness of the forex
market, which means that with some currency pairs (major pairs), there is more liquidity compared to
the less liquid exotic or minor pairs (Chaboud et al. , 2014). Liquidity refers to the ease with which an
asset or security can be bought and sold in the market without affecting the overall price of that asset or
security, and it is directly connected with the trading volume, which in turn can be described as the total
amount of each currency pair traded over a given period of time (Chaboud et al. , 2014). Higher trading
volumes tend to mean enhanced depth of markets and increased market participation hence traders
have high chances of effecting their transactions within high low and wide price range (Chakrabarty & Li,
2019). However, trading volume acts a variable of sentiment in most markets and can affect it; high
volume tends to be linked with volatile Market in terms of trading hence an opportunity for more
opportunities (Chakrabarty & Li, 2019). Traders have a special percentage of focus placed on volume
measurements in an effort to get a better feel of the market activity and possible turnarounds.
Therefore, when speaking of forex markets, two of the major factors that have a direct impact on the
market’s price formation, transaction costs, as well as trading processes, are liquidity and trading
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volume. Price manipulation plays an important role when choosing a pair of currencies, and the timing
of trades, in order to maximize profits from fluctuations in the market. Developing an analytical
perspective on the nature of the interdependence between liquidity and trading volume is pivotal to
fostering effective decision making in forex sphere.
2.2 Currency Pair Characteristics and Market Depth
Some attributes of these pairs include; A currencies turnover relative to other currencies is a measure of
its liquidity; Fluctuations in price within a short period depicts volatility; Trading session time of the
currency pair Dep (Chen & Shi, 2018). According to Chen & Shi (2018), major pairs are usually recognized
for their liquidity and big turnover by trader and are believed to possess higher level of depth compare
to exotic or minor pairs. The trading volume, depth, and platform can also affect the liquidity of a
currency pair since they determine its active participants (Chen and Shi, 2018). Also, volume’s pros show
that volatility, which portrays the amplitude of the changes in price influences market depth since
different traders have different risk tolerance levels and will, therefore, be inclined to different trading
styles. Currency pairs with strong and well developed economical backdrop and those involved with
more trading more often are the ones likely to have more depth in their market as measured by their
capacity to handle large orders without causing a large movement in the price levels as noted by
Chaboud et al. (2014). It is important for traders to fully comprehend the behaviors of all the available
currency pairs so as to be able to scope the depth of the market and, therefore, minimize the level of
risk in the process of executing a particular transaction or order (Chen & Shi, 2018). Other parameters
used in making trading decisions include Liquidity, volatility and hours of trading thus enabling market
participants to understand the ability of a particular market to handle big orders and potential change in
prices. , this knowledge makes it easier for the traders to adjust their trading style and manage the risks
they exposed to the specific currency pairs depending on the market conditions prevailing at a certain
time (Chen & Shi, 2018). For instance, some traders may prefer trading in the major currency pairs
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which have deep liquidity levels to ensure the large orders are executed efficiently and in a way that
does not cause slippage. On the other hand, a trader may be guard with his/her trade especially when
trading exotic or minor currency pairs because their market depth is usually shallow; the trader has to
come up with different alternatives such as adjusting on the position size or trading time (Chen & Shi,
2018).
2.3 Economic and Political Factors
Among the main market’s determinants are economic and political factors that affect market liquidity
and trading volume in the Fx markets (Christensen et al. , 2016). Gross domestic product together with
other standards such as inflation rates and central bank policies acts as the main drivers of the value of
currencies as well as trading volumes. For example, high and stable GDP and low levels of inflation make
investors expect the best in the country’s economy thereby causing the demand for its currency’s and
boosting the forex trading activities in the market. On the other hand, decisions by central banks like the
Federal Reserve or European Central Bank, regarding interest rates or Quantitative Easing can affect
trading in currency pairs and their values primarily because of basic factors involving borrowing costs
and available cash or money supply. It is noteworthy to identify how political factors, including election
results, geopolitical conflicts, and policy changes, can lead to increased fluctuations in the fluctuations in
the volumes of currency exchanges. Events such as elections for example bring about uncertainty as to
the future actions of the government policies and leadership this end up bringing about change in the
position that the investors take towards securities to cover up for the high risks through turnover. Other
factors influencing the high volatility in the currency market include political risks where things like trade
wars or conflict may occur that upset market attitudes or make them overemotional making rapid and
huge shifts in the value of the currency. Also, all policy decisions whether in the operational budgets or
in fiscally stimulating policy which in this case involves fiscal stimulus measures or trade agreements can
shift the expectations of the market and push market action and reaction towards it due to its likely
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impact on economic growth and monetary policy. As is illustrated by the interaction between economic
and political drivers and aspects such as market liquidity and trading volume, traders should be very
careful and adapt to existing changes. Furthermore, additional methods like the placing of stop-loss
orders and diversions of trader’s portfolio will enable them avoid overly dramatic flucuations in
profitability that can come as a result of periods of instability economically or politically.
2.4 Market Maker Inventory and Risk Appetite
Another study, by Conrad and Wahal (2018), has shown that the number of market makers and risk
appetite have a strong impact on market liquidity and turnover in the foreign exchange markets. These
market participants such as the banks and other financial institutions play a central role of offering bid
and offer prices and therefore being significant dealers in the trading of the securities (Conrad & Wahal,
2018). From Conrad and Wahal (2018), the amount and their willingness to hold inventories are primary
drivers of market sales and purchases and the liquidity of the market. Alternatively, during uncertain
periods or during phases when a sharp change in stock price is expected, market makers may choose to
either cut down their inventory or increase their bid-ask spreads so as to avoid potential risks not only
does it reduce the volume of trading sessions, but also impacts on liquidity. Market makers and total risk
thus become vital components of traders’ evaluation of condition liquidity and foreign exchange market
trade (Conrad & Wahal, 2018). Through the observation of the behavior of market makers and observing
the changes in the bid-ask spread and inventory positions of stocks, traders are in a position to make
better interpretations on the prevailing environment of the market in order to modify the trade
strategies they wish to employ. Furthermore, knowledge of the relationship between the market maker
and liquidity benefits traders in being able to foresee an occurrence of a liquidity shock and being in a
position to adapt to guard against such an outcome. Therefore, Market Maker inventory and Risk
Appetite are some of the factors that determine the level of liquidity and trading volumes in foreign
exchange markets and convey that these factors should be taken into consideration by the forex traders
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as part of inputs required while developing trading strategies within the global and interdependent
realm of forex trading.
3.0 Calculating and Interpreting Spot Exchange Spreads
3.1 Bid-Ask Spread and Pricing Mechanisms
Bid-ask spread that measures the difference between the price at which people are offering to sell their
securities, known as the ask price, and people’s willingness to buy these securities at bid price is a major
determinant of transaction costs in the financial markets (Dew-Becker et al. , 2020) . This spread depicts
the amount of remuneration of the market makers in exchange for initiating trades in the market and
ensuring that markets are always ready to make the trades (Bessembinder et al. , 2018). To sum up, the
definition of bid-ask spread is that the narrow spread is equal to small transaction costs and a large
spread means high costs of transactions for the members of the market (Dew-Becker et al. , 2020).
Knowledge of these pricing mechanisms is crucial for investors and traders in order to properly estimate
the price for these transactions and manage the impact of the market price on their transactions
(Dufour & Sönvik, 2019). Besides the bid-ask spread, transaction costs also include the costs like the
brokers’ fees, the exchange fees, and taxes for the actual transactions, any of which can erode the
profitability of the trades (Chaboud et al. , 2014). Market makers adjust bid-ask spreads according to
market conditions, which affect market liquidity, trading volume, and order flow (Dew-Becker et al. ,
2020). This implies that large liquidity and turnover results in narrow bid-asked spreads for the same
reason that there is cut off the cost of executing orders (Bessembinder et al. , 2018). On the other hand,
low LTV and trading volume result in larger bid-ask spreads because the market makers modify their
prices in response to the higher risk owing to low activity in trading for specific assets (Bessembinder et
al. , 2018). Another factor that affects cost is Bid/Ask spread whereby market participants should
carefully analyze the entry and exit points that they should take within the trading platforms (Dufour, &
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Solnik, 2019). By examining bid-ask spreads coupled with other measures of liquidity like depth of order
book and trading volume of a certain asset, traders may improve their knowledge of the particular
trading conditions and make viable decisions regarding a particular approach to trading.
3.2 Effective Spread and Market Impact Costs
Although bid-ask spread is a critical measure in illustrating the likely discrepancies in pricing quickly, it
does not give a precise picture of the real costs of undertaking trades (Engelberg et al. , 2016). The
effective spread goes beyond the bid-ask spread and comprises also market impact costs, which arise
from the market price consequences of an order’s size when it is executed in the market (Engelberg et
al. , 2016). These costs depend on several various aspects such as the size, type of the order, the existing
market condition, and the speed at which the transaction is executed among others (Fricke & Menkhoff,
2018). In Institutional orders have negative impact on the market as they are associated with large
orders which move the market prices and hence resulting to large market impact costs especially in less
liquid markets as proposed by Fricke & Menkhoff in their paper. Besides, market impact costs depend
on factors such as fluctuations, high volatility, and the speed of market execution since these aspects
may raise additional expenses, included in the overall transaction costs (Fricke & Menkhoff, 2018). In
return, by adopting an evaluation of the bid-ask spreads and the costs associated with market impacts, it
is possible to gain a better assessment of the overall transaction costs connected to trading (Fricke &
Menkhoff, 2018). With this information at hand, it enables the investors come up with better strategic
approaches that will ensure low transacting costs and achieve more efficient trade orders and
executions (Fricke & Menkhoff, 2018). Furthermore, improvements in trading technology including
details like NT and SOR allow the investors in hedging and other complexities of market impact cost
while allowing them to trade effectively and at the right price and time (Chaboud et al. , 2014).
Therefore, by an integration of these technological advancements with overall cost research, trading
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behavior of investors may be improved and better results in terms of return earned in the complex and
competing domain of financial market may be obtained in the long run.
3.3 Spread Volatility and Trading Strategies
The extent of variation in net of to bid-ask spreads through time is described as spread volatility and is
among the most important measures that determine the choice of trading strategies and risk
management methods (Dew-Becker et al. , 2020). The totality of this metric can be used to evaluate the
ever-evolving landscape of the market since it conveys investors’ moods, market’s depth and other
macro-economic factors (Harris, 2017). Low spread is mostly favorable in a stable market and during
times when investors want to stick to low-risk trades, while high spread volatility indicates otherwise
and forces traders to change their tactics and strategies (Fricke & Menkhoff, 2018). Compared to quiet
periods, traders can implement more cautious approaches during periods of volatility, for example,
decreasing the exposure or increasing hedge operations as a way of minimizing losses and preserving
assets (Fricke & Menkhoff, 2018). Furthermore, realizing the nature of spread sprawl is crucial in
devising trading strategies that can effectively demonstrate resilience relating to shocks that might
characterize a specific market (Fricke & Menkhoff, 2018). It may be preferred that traders conduct
technical analysis and volatility modeling to analyze spread volatility and when a signal may be valuable
for trading (Chaboud et al. , 2014). The bid-ask spreads not only offer valuable information about the
current prices but, with historical data on the volatility in the spread and the monitoring of the current
trading situation, traders can understand the behavior of the spreads, which will help them to expect
the price movements (Fricke & Menkhoff, 2018). Moreover, algorithm trading with automated
execution environments make it possible for traders to respond appropriately to pinned factors in
spread volatility and complete trade transactions at the best price levels as suggested by Huang et al. ,
2020. In addition, incorporating spread volatility analysis in risk management policies assist traders to
manage market risk exposure and control for capital in situations of heightened market volatility (Harris,
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2017). Much the same way firms have adopted strategies of how to dispell volatility and how to employ
advanced state techniques for effective trading, traders can be in a position to manage volatilities in an
enhanced manner within the ever changing environment in the trading of finances.
3.4 Spread Analysis for Transaction Cost Estimation
It is noteworthy that spread analysis is an indispensable instrument for investors which allows to receive
vital information about estimation of the transaction costs and choice of the strategies of the
organization of trades (Engelberg et al. , 2016). In this way, by analyzing historical spread data, investors
obtain the necessary knowledge about the pattern and trends of bid-ask spreads, given this knowledge,
they can more accurately decide on the time to perform the trade and make the optimal orders (Fricke
& Menkhoff, 2018). This exercise helps investors in the establishment of the correct entry and exit
points hence enhancing on working efficiency and reducing transaction costs that would have been
incurred (Bessembinder et al. , 2018). In addition, spread analysis makes it easy to compare transaction
costs of particular trading strategies at various markets and during different periods and help investors
to choose the most appropriate and least costly execution techniques (Fricke & Menkhoff, 2018).
Analyzing the spread dynamics that affected the mentioned instruments and related markets, investors
can undertake appropriate decisions to accurately configure their trades as well as improve the returns
on their portfolios (Bessembinder et al. , 2018). The definition of spread analysis in the investment
process helps the investors to get more insight into the market liquidity and price levels of the specific
assets that can be invested in thus it helps the investors to work on the clarity of the financial market
(Bessembinder et al. , 2018). Also, technology has developed mechanisms including high-frequency
trading algorithms and smart order routing systems for the investors to harness spread analysis
knowledge and execute the operations most appropriately (Huang et al. , 2020). Altogether, by using
these tools in context with high-level spread analysis benefits can be obtained in terms of trade
execution and therefore reach higher portfolio returns (Bessembinder et al. , 2018). Summing up, the
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assessment of the spreads is an indispensable tool for trading strategies and provides investors with the
proper decision-making tools, means to control buy/sell transactions, and measures to maximize their
performance in an ever-changing trading environment.
4.0 Spot Exchange Spread Variations and Patterns
4.1 Intraday and Daily Spread Patterns
It is an established fact that foreign exchange intraday and daily spread dynamics play an important role
in global markets and changes in market liquidity while trading during a day. Generally, bid-ask spreads
are lower during the period of the day that experiences the most trading since the liquidity is also high;
bid-ask spreads are wider during low trading periods (Gonzalez-Rozada & Tuesta, 2017). This effect
mainly ascribes to the global synchronous trading time of various financial markets such as the cross-
over time between London and New York that registered the highest volume and liquidity (García &
Norli, 2019). Such a scenario boosts trading volumes in the world markets and makes the spreads
tighten, improving the overall trading cost for various participants of the market (Gonzalez-Rozada, and
Tuesta, 2017). On the other hand, increased spreads can be observed at other time FIN when trading
goes down for instance after the New York session but before the Asian session due to low
liquidity(Gonzalez-Rozada & Tuesta, 2017). Analyzing such characteristics of intraday and daily bid-ask
spreads is crucial for the traders who are in the process of figuring out how to fine-tune their trading
strategies. Thus, by synchronizing its trading activities with periods of high liquidity and low bid/ask
spread, a trader can effectively reduce the relative cost of trading (that is, the effect of transaction costs
of the total profit/loss), as suggested by García & Norli (2019). Furthermore, this knowledge enables the
traders to avoid trading during spread values and potential fluctuating prices by implementing the
appropriate measures(s) in place (Gonzalez-Rozada & Tuesta, 2017). Furthermore, understanding when
the major financial centres’ trading period is also useful for clients as they are in a position to foresee
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and plan for changes in the stream of liquidity more effectively. The implementation of spread pattern
analysis into the trading approach also proves not only to improve the effectiveness of executing trades
but also to increase the extent of understanding of market behavior and, in turn, to make better
decisions and achieve more effective results in trading (García & Norli, 2019).
4.2 Regional and Cross-Currency Spread Differences
Cross currency and regional spread variations are caused by the dissimilarities in overall market
conditions and market context of the area to which any currency belongs and of other currencies in the
opposite currency pair (García & Norli, 2019). European currency or EUR and USD constitute a major
pair, and similarly, JPY and USD are major currencies, which means that the spreads in these pairs would
tend to be narrower since these pairs are heavily traded (Hau & Rey, 2016). It needs to be said that
these pairs have a high number of market participants, including banks, financial institutions, and
private traders, which helps increase market depth and thus decrease the transaction costs (García &
Norli, 2019). On the other hand, it is standard to observe greater variation or spreads in lower turnover
currencies that include USD/TRY or USD/ZAR; this is due to high risks and low turnover of this market
(García, Norli, 2019). Higher inactivity reduces the possible trading volume and thus the cost and
fluctuation in such pairs remain higher than that of the pairs with higher activity of trading participants.
The following are some of the reasons why spread varies in different markets: Differences in the market
regulations of different countries, differences in the trading hours and the presence of market makers
and makers. (Gonzalez-Rozada & Tuesta, 2017). For example, limit and stop out prices by trading venues
including regulatory markets with well defined trading infrastructure such as US and European markets
have been recorded to exhibit more consistent and narrow spreads than the emerging markets with
comparatively ill defined and less strict regulatory environments and trading practices. The co-
ordination of trading sessions of various financial markets such as New York, London also help in
controlling the spread factor. During these overlappings, market frogs are attained at peak levels,
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leading to more conducive spreads and cheaper transaction costs (Hau & Rey, 2016). On the other hand,
in some cases when there are only regional market players involved in trading, the spreads may increase
due to low movement in the markets and fewer participants into the market.
4.3 Impact of Macroeconomic News and Events
Macroeconomic news and event have a large effect on bid-ask spreads since trading activity is affected
by the general economic environment, resulting in a higher spread as traders learn to adapt to the new
conditions (Hodrick & Prescott, 2019). This is due to the fact that certain macro factors that include
central bank communication, economic statistics as well as geo-political factors are capable of causing
dramatic price changes accompanied by large amounts of volatilities (Hau & Rey, 2016). For instance, a
change in rates of interest by a central bank may sharply affect the rate of expectation and trigger shifts
in currency demand and supply and thus shift traders analysis. During such times market maker for each
security widens the spread in a bid to hedge on the increased risk and possible market disturbance
(Hansen & Sargent, 2018). Since the access to information is conditionally uncertain, market makers
need to protect themselves from possible losses due to fluctuations in the market and reduce the
spreads; thus, counterparty risk adds to the width of the bid-ask spread to compensate for the higher
volatility and less liquid markets (Hau & Rey, 2016). Mack and Nelson (2018) noted that macroeconomic
information release can cause a significant shift in spread behavior and, therefore, evaluating the
influence of macroeconomic news on the spread behavior is important for traders to develop an
effective plan in periods of changing market conditions according to Hodrick and Prescott (2019). Having
information on when the latter is likely to occur and what major political events are expected among
other things makes it easier for traders to track shifts on the economic calendar in order to avoid market
shocks. It means that they adapt themselves in terms of trading policies, for example, it is better for
them not to trade during those periods or in case of emergencies use hedging policies and procedures to
minimize possible losses (Hansen & Sargent, 2018). Therefore, employing items such as, economic
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calendar and news feeds assist traders plan and predict for market influential events in order to make
the right decisions. Complex and sophisticated trading strategies and signalling can be valuable in
understanding tendencies of the spread and in a good timing of trades by taking into account the
macroeconomic environment. These technologies are capable of handling large quantities of
information and delivering results in an instant, which would allow the trader to react more promptly to
developments in the market and reduce the influence of the amplified spread on their expenses (Hau &
Rey 2016).
4.4 Effects of Market Structure and Regulations
These are mechanisms of market structure and regulations hugely affecting bid-ask spreads deeply
impact general market and its efficiency (Hansen & Sargent, 2018). Specific policy measures and
structures that enforce disclosure of trade information and regulatory requirements translating into
competitive environment as understood in the context of Hau & Rey (2016) play a role in the reduction
of spreads as a result of minimizing information asymmetry and improving the efficiency of the market.
In this context, it remains remarkably evident that market structure and regulations do impact bid-ask
spreads in influential ways that precipitate changes in market liquidity and efficiency. Trade
transparency measures that comprise of regulatory structures that encourage the production of trade
information will have high efficiencies due to the reduction of information asymmetry hence having low
price spread (Hau & Rey, 2016). Due to the elimination of the information advantage that would
otherwise be available to certain participants in the market, it ensures that all players have equal access
to trade information and hence levels the playing ground. Such transparency attracts more people to
participate in trading hence coming up with large liquidity in a market, thereby cutting down the
expenses in trading (García & Norli, 2019). On the other hand, restrictive regs or market structures
which do not allow for keen competition often results in wider , and low liquidity. Overall, where
competition is limited market makers can offer wider bids and offers without risk of being pre-empted
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by other market makers and the resulting increase in trading costs to the trader and overall inefficiency
of the market are further discussed by García and Norli, 2019. Another factor is brought into play by the
use of electronic trading systems, that is, reduction of spreads and enhancement of the overall
efficiency in the markets as a result of enhanced access in addition to increased market participation by
the concerned parties (Gonzalez-Rozada & Tuesta, 2017). Such platforms enhance the speed of
executing trades and minimize the costs of trading, also allowing a larger number of people to trade
within the financial market. The competitors participating in these platforms are usually more in number
and this makes it easier to get a higher number of participants thus the bid-ask spreads are usually tight
and the liquidity improves.
5.0 Implications for Foreign Exchange Market Participants
5.1 Spread Considerations for Institutional Investors
Large trading by institutional investors like mutual funds, pension funds, and hedge funds impacts bid-
ask spread therefore the investors should avoid large trades to reduce transaction costs of high
immediate trading demand (Lambert & Le, 2020). Because of the large trading volumes, relatively small
values of competitive spreads matter and contribute to the total trading costs which, in turn, affect the
portfolio performance (Jiang & Li, 2020). These investors use efficient and effective trading techniques
and techniques to enter and exit trades with reduced transaction or implementation cost and to make
the most of differences in the costs of executing trades across the various markets (Kung & Schmid
2019). Some of these strategies may include usage of algorithmic trading where large orders are broken
down into small parcels and executed as prices fluctuate in an effort to ensure only fractions of the lots
are traded during periods of high volatility and only at conditions of favourable spread. Large traders
such as institutional investors may use dark pool or also known among other as the ATS to make large
trades anonymously thus minimizing on the market impact as well as being able to obtain the needed
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better pricing (Lambert & Le, 2020). Even direct communication with agents tends to be also as often
used to negotiate exclusive better spreads with the help of agents given large volumes of transactions
employed by institutional investors (Kim & Kim, 2017). These can bring improved pricing terms for what
they trade, lower fees charged, or better quality all of which improves the cost of trading for them.
Large investors may apply analytical tools to evaluate conditions in the securities markets and
determine specific time when it is necessary to implement their trades, factors such as liquidity,
volatility and recent trends in prices might be considered (Jiang & Lee, 2020). For the institutional
trader, the inherent task of forming a cross-product spread, as well as awareness of the different trading
obstacles, are crucial factors in achieving the lowest cost and highest return on investment. Analysing
bid-ask spreads and using such approaches as stealth trading and a combination of a range of other
techniques together with the negotiations with brokers, institutional investors will be in a position to
control transaction costs, avoid the spiking of the volume, as well as improve the overall outcome of an
investment.
5.2 Retail Investor Access and Pricing
For instance, retail investors often experience a larger bid–ask spread in comparison with institutional
investors since they are usually able to trade lower volume in the market and consequently have less
power in negotiating the price (Kim & Kim, 2017). Although, it is more convenient for the retail investors
to enter the market with competitive pricing given through movements of electronic trading platforms
and online brokers accompanied by lower realized transaction costs and better spreads than through
regular brokerage houses (Lambert & Le, 2020), they have to be cautious of the hidden costs. For
instance, some brokers may lure their clients by proposing very low commission fees but set much larger
spread which makes overall trading costs for the client higher than they appear at first sight
(Kouwenberg & Verschoor, 2018). Besides, the quality of executions that are made through electronic
trading platforms depends on factors such as the order routing and the market making arrangements
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that are in place with a broker this shows that this due diligence should be conducted when engaging a
broker (Christensen et al. , 2016). Moreover, the last concerns are already at the retail level and include,
for instance, price improvement or lack of it, order routing speed or slippage possibilities. Slippage, on
the other hand, arises when there is a divergence between the price that is paid when the order is
executed and the price expected at the time of order placement and execution could be due to high
volatility or lack of deep liquidity (Hau & Rey, 2016). By appreciating these facets and appropriately
employing proper trading approaches, the retail investors can be able to reduce their general trading
costs and thereby enhance their outcomes. Among them is the one that suggests that limit orders rather
than market orders should be employed, as Kung & Schmid have noted in their research. Limit orders
enable clients to set the quantity in which they want to buy or sell at a predefined price not affected by
the real-time bid-ask spread. This approach also helps to control the transaction costs, along with
achieving more efficient control over trade in terms of timing and volatility.
5.3 Spread Management for Market Makers
Market makers, according to Lambert & Le (2020), continue to perform crucial functions that ensure the
effectiveness of financial markets by offering bid and offer quotes as enshrined by the NFMA Act section
27 sub section 1. Spread management should thus be central to such entities to ensure that they meet
the need to provide liquidity while; at the same time mitigating the risk that comes with holding stocks
as pointed out by Jiang & Li (2020). It is customary for market makers to be prima facie, which implies
that they purchase securities from sellers in the market and sell them to buyers in the market; this
means that the market maker holds the risk of holding stocks in its inventory waiting for a counter-party
with whom to transact (Chakrabarty & Li, 2019). They employ quantitative approaches such as value-at-
risk (VaR) and scenario analysis to evaluate and minimize the effect of unfavorable changes in
characteristics that either affect or determine the price of their assets (Kung & Schmid, 2019).
Furthermore, market makers use different methods such as delta hedging that involves making minor
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adjustments to the position in other related derivatives so that the market maker does not have a
directional risk in any of the instruments (Chen & Shi, 2018). Market makers change their spreads with
respect to changes in market rates as an attempt to minimize their risks (Kouwenberg & Verschoor,
2018). For instance, in illiquid markets, which is normally characterized by frequent fluctuations, market
makers may increase their bid-ask spread with the intention of diversifying any additional hazards that
come with the variability in the market (Gonzalez-Rozada & Tuesta, 2017). In a similar manner, when the
overall market depth shrinks, market makers may expand their bid-ask spreads to contain the cost of
supplying and managing inventories, plus the risks associated with trading in less liquid markets (Hau &
Rey, 2016). Another factor is that market makers have also benefited from the enhancement of
technological capabilities, which has ultimately enhanced their capabilities and performance
(Christensen et al. , 2016).
5.4 Regulatory Oversight and Transparency Initiatives
Market regulation and Increased transparency play a massive role in making sure that investor
protection is done thoroughly, where investors have equal access to the information, this helps to get
rid of cases, which involves manipulation within the markets, thereby enhancing efficiency (Lambert &
Le, 2020). These comprise of the preparation of trade as well as price reports, which assist in lowering
bid-ask spreads since actual market features concerning the market are offered to the participants in
the market (Kim & Kim, 2017). Indeed, measures like central clearing for derivatives as well as for other
products non-centralized contracts not only bolstered market integrity but also mitigated counterparty
risk, and to some extent pinned down the extent of tighter spreads (Amir, Lambert & Le, 2020).
Mentioned previously, favourable and broad legislation that promotes competitiveness amongst market
makers aids in the reduction of the spread and in enhancement of the market depths (Jiang & Li, 2020).
These individually advocated measures make up the way to improve the effectiveness of the financial
markets, as well as provide value additions to all the associated players (Kouwenberg & Verschoor,
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2018). In addition, the transparency laws that categorize under ;disclosure rules’ regulating insider
trading restrictions provide investor confidence, and reputation of the business marketplace. There is
also awareness of independent regulatory bodies, whichmonitor the operations of the market and
ensure that the appropriate legislation is being complied with (Hau & Rey, 2016). Moreover,
advancement in technology also means that any regulatory efforts to monitor trading activities will be
more effective with robotics that can easily point out and deter manipulative behaviors in the process
(Conrad & Wahal, 2018). Combined, the elements on the regulation of financial markets, information
transparency activities and technological support present a considerable backdrop for the safeguard
and/or enhancement of the financial markets for offered greatest advantage to investors or every
participant anticipated in the course.
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