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What Is a Spread?
A spread can have several meanings in finance. Generally, the spread refers to the difference between two prices, rates, or yields. 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.
Understanding Spread
Spread 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 bid-ask spread is also known as the bid-offer spread and buy-sell. This sort of asset spread is influenced by a number of factors:
- Supply or "float" (the total number of shares outstanding that are available to trade)
- Demand or interest in a stock
- Total trading activity of the stock
For securities like futures contracts, options, currency pairs, and stocks, the bid-offer spread is the difference between the prices given for an immediate order—the ask—and an immediate sale – the bid. For a stock option, the spread would be the difference between the strike price and the market value.
One of the uses of the bid-ask spread is to measure the liquidity of the market and the size of the transaction cost of the stock. For example, on Jan. 11, 2022, the bid price for Alphabet Inc., Google's parent company, was $2,790.86 and the ask price was $2,795.47.1 The spread is $4.61. This indicates that Alphabet is a highly liquid stock, with considerable trading volume.
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.
Spreads are priced as a unit or as pairs in future exchanges to ensure the simultaneous buying and selling of a security. Doing so eliminates execution risk wherein one part of the pair executes but another part fails.
Types of Spread
The yield spread is also called the credit spread. The yield spread shows the difference between the quoted rates of return between two different investment vehicles. These vehicles usually differ regarding credit quality.
Some analysts refer to the yield spread as the “yield spread of X over Y.” This is usually the yearly percentage return on investment of one financial instrument minus the annual percentage return on investment of another.
To discount a security’s price and match it to the current market price, the yield spread must be added to a benchmark yield curve. This adjusted price is called an option-adjusted spread. This is usually used for mortgage-backed securities (MBS), bonds, interest rate derivatives, and options. For securities with cash flows that are separate from future interest rate movements, the option-adjusted spread becomes the same as the Z-spread.
The Z-spread is also called the yield curve spread and zero-volatility spread. The Z-spread is used for mortgage-backed securities. It is the spread that results from zero-coupon treasury yield curves which are needed for discounting pre-determined cash flow schedule to reach its current market price. This kind of spread is also used in credit default swaps (CDS) to measure credit spread.
What Is a Yield Spread?
A yield spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, issuer, or risk level, calculated by deducting the yield of one instrument from the other. This difference is most often expressed in basis points (bps) or percentage points. Yield spreads are commonly quoted in terms of one yield versus that of U.S. Treasuries, where it is called the credit spread.
What Is Option-Adjusted Spread (OAS)?
The option-adjusted spread (OAS) measures the difference in yield between a bond with an embedded option, such as an MBS, with the yield on Treasuries. It is more accurate than simply comparing a bond’s yield to maturity to a benchmark. By separately analyzing the security into a bond and the embedded option, analysts can determine whether the investment is worthwhile at a given price.
What Is the Zero-Volatility Spread (Z-Spread)?
The zero-volatility spread (Z-spread) is the constant spread that makes the price of a security equal to 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 can tell the investor the bond's current value plus its cash flows at these points. The spread is used by analysts and investors to discover discrepancies in a bond's price.