What is Spread in the Financial Market
Have you ever heard of the spread? The term is frequently mentioned in economic news and financial content. Moreover, it is a part of both your investments and the services you use from a bank.
Therefore, understanding what it means and how to calculate it can influence your trades! In this article, you will learn about the banking spread and how it impacts your investments.
So, what is Spread?
Spread, essentially, is the difference between the rates charged and used by banks.
Those who invest in fixed income, such as in CDs (Certificates of Deposit), LCI (Real Estate Credit Letters), and LCA (Agribusiness Credit Letters), know that these securities function as loans made by investors to banks.
In turn, the bank also lends money to its clients and charges an interest rate. Thus, the spread is the difference between the interest paid by the bank to the investor and the interest charged to clients. This difference needs to exist for the operation to be profitable.
Difference between Spread in the financial market and banking spread
Spread in the Financial Market
In the financial market, spread can be defined as the difference between the buying and selling prices of a stock. Thus, it is widely used in speculative operations and investments in the stock market to determine profitability.
If, in the order book, the lowest selling price of a stock is $10.00 and the highest buying price is $12.00, then the spread of this stock will be $2.00. Thus, to gain from this trade, one needs to sell the stock for at least $12.01. However, if the spread is less than this quote, a loss will be incurred with the sale.
The lowest selling price is known as the “ask,” while the highest buying price is known as the “bid.”
The bid is the best buying price for the asset. Thus, this value occupies the top of the order book. In turn, the ask is the best quote the market is willing to pay, that is, the selling price.
Therefore, the spread is used to calculate the possible return rate in various asset buying and selling operations.
In banks, the spread is the difference between what a bank pays in interest to an investor and what it charges in interest for loans. For example, if a bank pays 5% interest per year to an investor and lends that money at 25%, its spread is 20 percentage points.
A study by the World Bank, which presented a map of banking spreads, shows that the Brazil spread is one of the highest in the world! Here are some percentages reported by the institution:
South Africa: 3.2%
This means that the rate banks pay to investors is much lower than what they charge for their loans.
According to World Bank data, only $0.13 is recovered from every $1 borrowed here. For comparison, the global average is $0.34 per $1.
This low credit recovery directly impacts the administrative costs of banks, which is one of the components of the spread. And this mechanism is the main tool used to define the banks’ profit in their operations.
To define their spread, banks take into account the risks of the operation, such as default rates, taxation, and other related costs, in addition to profit expectations. Almost three-quarters of the Brazilian banking spread are composed of default (39.95%) and bank profit (34.02%).
However, looking at it from another investment perspective, the high spread is one of the reasons that make the banking sector one of the most profitable in the country. Shareholders of banks are, in a way, receiving part of the spread back in the form of dividends.
What is the impact of the spread on investors?
As you can see, the spread is a very important indicator for investors. In fixed income, it helps assess profitability and compare alternatives.
In the stock market, it is linked, among other things, to the volatility and liquidity of assets. Traders and speculators rely on the spread to determine their moves in the stock market.
Regarding price fluctuations in the stock market, when a spread ends the trading day in a selling position, there is buyer interest. On the other hand, when it closes below, there is an indication of selling strength.
These variations indicate upward or downward trends in prices, fundamental issues in day trading and other speculation strategies, for example. In this sense, the higher the spread, whether negative or positive, the higher the volatility of that asset.
In turn, liquidity is related to the trading volume of a particular asset. When there is high liquidity, the spread is usually lower. Otherwise, less liquid assets have a long spread.
Moreover, the spread also determines the cost of credit in a country, something fundamental when directing investments.
As you have seen, the spread is an important indicator for your investments. It demonstrates price variations in assets and differences in profitability between fixed income securities.
Knowing how to calculate and assess the spread is an excellent strategy to maximize your long-term gains.
So, use the information from this content to evolve in your investments.