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5:02 PM
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A: How does a dealer earn the bid-ask spread?

sheegaon Market-makers (which you term dealers) earn the bid-ask spread by buying and selling in as short a window as possible, hopefully before the prices have moved too much. It is not riskless. The spread is actually compensation for this risk. The less liquid an asset is, the more time is likely to...

 
Tim
Tim
Thanks! (1) How is spread compensation for the risk? (2) What does "information" mean in "more information likely to arrive"?
(3) Are market-makers same as dealers? (note that I just learned the difference between brokers and dealers.) Do they actually make the markets?
 
sheegaon
sheegaon
@Tim (3) Dealers typically serve a market-making function (though sometimes they are dealing in products which they also originate), and certainly not all market makers are dealers. Your statement regarding spreads applies to dealers doing market-making, and also non-dealer market-makers.
@Tim Not sure what is your question about (1), seems pretty clear to me. (2) Information is deliberately vague, could be anything which moves the price.
 
Tim
Tim
For (1), I am not clear why spread can be compensation for the risk.
 
sheegaon
sheegaon
What do you mean why. If one party agrees to take risk on behalf of another, it's only natural to demand compensation. In the case of market-making, that compensation is the spread.
 
Tim
Tim
Firstly, thanks for taking time with me! Are "buy" and "sell" in the definition of "spread" actions of investors or of dealers? In other words is spread a concept that applies only to the time point when dealers sell their assets to investors?
 
sheegaon
sheegaon
5:09 PM
OK, lets get some terms straight, rather than buy and sell, use bid and offer.
Investors buy from dealers at the offer and sell to them at the bid.
For every buyer there is a seller
The investor "pays" the spread, the dealer "receives" the spread.
 
Tim
Tim
Is it right that the bid price and offer price in definition of "spread" occur in different time, and the latter happens when dealers buy in assets and the former when them sell the assets?
The bid and offer prices are not determined by the dealers, so they can earn or lose money depending on which price is bigger?
 
sheegaon
sheegaon
Bid and offers are "quotes," and they are typically simultaneous. When a trade occurs, it may occur at the bid, offer, or in between.
Each dealer (really should be saying market-maker, MM, here) gives his own bid/offer.
The market bid/offer is the best (highest bid, lowest offer) of all MMs.
Market maker
A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be adversely selected at a premium proportional to the trading range at which they are willing to provide liquidity. In currency exchange Most foreign exchange trading firms are market makers and so are many banks, although not in all currency markets. In foreign exchange (or FX) trading, where ...
 
Tim
Tim
Will dealers lose money when the market offer price is lower than the market bid price?
 
sheegaon
sheegaon
That can't happen except due to error.
(in a given market, it can happen in different locations, say)
 
Tim
Tim
Then why do dealers suffer risks as mentioned in your reply to my post?
 
sheegaon
sheegaon
5:21 PM
MMs are offering to trade, at either price, the risk is that all the orders will be in one direction and then prices will move.
A trade is completed when someone "hits" a MM bid or "lifts" a MM offer. Then the MM gains or loses inventory. As the inventory is accumulated, there is a risk that the prices move such that the MM is unable to load the inventory at a better price than which it was acquired.
gg, nice chatting w/u
 

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