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TL;DR

The difference between the best ask (lowest sell price) and best bid (highest buy price) in a market. It represents the cost of immediacy and the market maker's compensation for providing liquidity.

By Valenke Exam Prep Team·Last updated 2026-06-03

Bid-Ask Spread

The difference between the best ask (lowest sell price) and best bid (highest buy price) in a market. It represents the cost of immediacy and the market maker's compensation for providing liquidity.

Why it matters for interviews

The spread is a direct trading cost and a key variable in execution algorithms. Understanding what determines spreads (adverse selection, inventory risk, competition) is essential for market microstructure interviews.

Definition and Mathematical Foundation

The difference between the best ask (lowest sell price) and best bid (highest buy price) in a market. It represents the cost of immediacy and the market maker's compensation for providing liquidity.

Application in Quantitative Finance

The spread is a direct trading cost and a key variable in execution algorithms. Understanding what determines spreads (adverse selection, inventory risk, competition) is essential for market microstructure interviews.

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Frequently Asked Questions

What determines the bid-ask spread?▼
Three components: adverse selection cost (trading against informed traders), inventory holding cost (risk of position changes), and order processing cost. In competitive markets, the spread narrows to approximately the adverse selection component.
What is the effective spread?▼
Twice the difference between the execution price and the midpoint: \( 2|P_{exec} - P_{mid}| \). It captures actual trading costs, which may differ from the quoted spread due to price improvement or hidden orders.
How does the spread relate to volatility?▼
Spreads widen with volatility because adverse selection risk increases (informed traders are more likely to trade), and inventory risk grows. This is why spreads spike during market stress.