Real Rate of Return

The real rate of return formula is the sum of one plus the nominal rate divided by the sum of
one plus the inflation rate which then is subtracted by one. The formula for the real rate of
return can be used to determine the effective return on an investment after adjusting for
inflation.

The nominal rate is the stated rate or normal return that is not adjusted for inflation.

The rate of inflation is calculated based on the changes in price indices which are the price on
a group of goods. One of the most commonly used price indices is the consumer price
index(CPI). Although the consumer price index is widely used, a company or investor may
want to consider using another price index or even their own group of goods that relates more
to their business when calculating the real rate of return.

For quick calculation, an individual may choose to approximate the real rate of return by
using the simple formula of nominal rate - inflation rate.

Example of Real Rate of Return Formula

An example of the real rate of return formula would be an individual who wants to determine
how much goods they can buy at the end of one year after leaving their money in a money
market account that earns interest.

For this example of the real rate of return formula, we must assume that the individual wants
to purchase the exact same goods and same proportion of goods that the consumer price
index uses considering that it is used often to measure inflation.

For this example of the real rate of return formula, the money market yield is 5%, inflation is
3%, and the starting balance is $1000. Using the real rate of return formula, this example
would show

which would return a real rate of 1.942%. With a $1000 starting balance, the individual could
purchase $1,019.42 of goods based on today's cost. This example of the real rate of return
formula can be checked by multiplying the $1019.42 by (1.03), the inflation rate plus one,
which results in a $1050 balance which would be the normal return on a 5% yield.

http://financeformulas.net/Real_Rate_of_Return.html
What is a 'Bid-Ask Spread'

A bid-ask spread is the amount by which the ask price exceeds the bid price for an asset in
the market. The bid-ask spread is essentially the difference between the highest price that a
buyer is willing to pay for an asset and the lowest price that a seller is willing to accept to sell
it.

BREAKING DOWN 'Bid-Ask Spread'

The bid-ask spread is a reflection of the supply and demand for a particular asset. The bids
represent the demand, and the asks represent the supply for the asset. The depth of the bids
and the asks can have a significant impact on the bid-ask spread, making it widen
significantly if one outweighs the other or if both are not robust. Market makers and traders
make money by exploiting the bid-ask spread and the depth of bids and asks to net the spread
difference.

For example, if the bid price for a stock is $19 and the ask price for the same stock is $20,
then the bid-ask spread for the stock in question is $1. The bid-ask spread can also be stated
in percentage terms; it is customarily calculated as a percentage of the lowest sell price or ask
price. For the stock in the example above, the bid-ask spread in percentage terms would be
calculated as $1 divided by $20 (the bid-ask spread divided by the lowest ask price) to yield a
bid-ask spread of 5% ($1 / $20 x 100). This spread would close if a potential buyer offered to
purchase the stock at a higher price or if a potential seller offered to sell the stock at a lower
price.

The Bid-Ask Spread's Relation to Liquidity

The size of the bid-ask spread from one asset to another differs mainly because of the
difference in liquidity of each asset. Certain markets are more liquid than others. For
example, currency is considered the most liquid asset in the world, and the bid-ask spread in
the currency market is one of the smallest (one-hundredth of a percent); in other words, the
spread can be measured in fractions of pennies. On the other hand, less liquid assets, such as
small-cap stocks, may have spreads that are equivalent to 1 to 2% of the asset's lowest ask
price.

Elements of the Bid-Ask Spread

Some of the key elements to the bid-ask spread include a highly liquid market for any
security in order to ensure an ideal exit point to book a profit. Secondly, there should be some
friction in the supply and demand for that security in order to create a wide spread. Traders
should use a limit order rather than a market order; meaning the trader should decide the
entry point so that he doesn’t miss the spread opportunity. There is a cost involved with the
bid-ask spread, as two trades are being conducted simultaneously. Finally, the bid-ask spread
trades can be done in most kinds of securities — the most popular being foreign exchange
and commodities.

Understanding how a bid-ask spread works could help in your investing strategy. Read How
to Calculate the Bid-Ask Spread and The Basics of the Bid-Ask Spread to learn more about
this concept.
Each investor is unique and so are his investment needs?

Every investor is different because

 with different financial goals,
 different tolerances to risk,
 different personal situations and
 different age and backgrounds
 different desires and basic requirements

Objectives being the type of return being sought, while constraints include factors such as
time horizon, how liquid the investor is, any personal tax situation and how risk is handled.

One way to define what investors want is in terms of the personal financial goals they want to
achieve. Goals may include:

• Setting money aside for near-term spending or an emergency or rainy-day fund.

• Current income.
• Some appreciation in investment value with reduced volatility.
• Long-term growth to fund retirement.

Investors bring inherent conflicts in the door with them:

 They want maximum growth and safety at the same time.

 They want a pool of money that allows them to enjoy life after work, and they have a
wonderful list of things they want to enjoy today.
 They want equity-like returns without volatility.
 When markets move upward, investors want to get a "piece of the action" and jump
on board, doing the opposite when markets go down. This sets up a buy-as-prices-get
higher-sell-as-they-get-lower paradigm.

Short selling is beneficial for both investors and markets

What is 'Short Selling':

1. Short selling is the sale of a security that is not owned by the seller or that the seller has
borrowed.
2. Short selling is motivated by the belief that a security's price will decline, enabling it to
be bought back at a lower price to make a profit.
3. Short selling may be prompted by speculation, or by the desire to hedge the downside
risk of a long position in the same security or a related one.

Advantages:
1. Short selling strengthens the market by exposing which companies' stock prices are too
high. In their search for overvalued firms, short sellers can discover accounting
inconsistencies or other questionable practices before the market at large does.
2. Short selling plays an important role in capital markets for a variety of reasons, including
more efficient price discovery, mitigating price bubbles, increasing market liquidity,
facilitating hedging and other risk management activities.
3. Short-selling is considered an essential feature of the securities market not just for
providing liquidity, but also for helping price corrections in over-valued stocks.

Are there any drawbacks of short-selling?

1. Can easily destabilise the market.
2. They believe that short-selling can exacerbate declining trend in share prices, increase
share price volatility, and force the price of individual stocks down to levels that might
not otherwise be reached.
3. They also argue that declining trend in the share prices of a company can even impact its
fund-raising capability and undermine the commercial confidence of the company.
4. In a bear market in particular, short-selling can contribute to disorderly trading, give rise
to heightened short-term price volatility and could be used in manipulative trading
strategies.

Market Efficiency

Market efficiency refers to the degree to which market prices reflect all available, relevant
information. If markets are efficient, then all information is already incorporated into prices
and so there is no way to "beat" the market since there are no under- or over-valued securities
available.

efficient market hypothesis (EMH) stated it is not possible for an investor to outperform the
market, and that market anomalies should not exist since they will immediately be arbitraged
away. Fama later won the Nobel Prize in economics for his efforts. Investors who agree with
this theory tend to buy index funds that track overall market performance and are proponents
of passive portfolio management.

At its core, market efficiency measures the ability of markets to incorporate information that
provides the maximum amount of opportunities to purchasers and sellers of securities to
effect transactions without increasing transaction costs.

The weak-form of market efficiency assumes that past price movements have no effect on
future rates. Given this assumption, momentum rules or technical analysis techniques that
some traders use to buy or sell a stock are invalid. The semi-strong form of market efficiency
assumes that stocks adjust quickly to absorb new public information, so that an investor
cannot benefit over and above the market by trading on that new information. The strong-
form market efficiency says that market prices reflect all information both public and private,
building on and incorporating the weak-form and the semi-strong form.

 Strong efficiency - This is the strongest version, which states all information in a market,
whether public or private, is accounted for in a stock price. Not even insider information
could give an investor an advantage.
  Semi-strong efficiency - This form of EMH implies all public information is calculated into a
stock's current share price. Neither fundamental nor technical analysis can be used to
achieve superior gains.
 Weak efficiency - This type of EMH claims that all past prices of a stock are reflected in
today's stock price. Therefore, technical analysis cannot be used to predict and beat a
market.

1. Weak-form efficiency

Prices of the securities instantly and fully reflect all information of the past prices. This
means future price movements cannot be predicted by using past prices, i.e past data on stock
prices is of no use in predicting future stock price changes.

2. Semi-strong efficiency

Asset prices fully reflect all of the publicly available information. Therefore, only investors
with additional inside information could have an advantage in the market. Any price
anomalies are quickly found out and the stock market adjusts.

3. Strong-form efficiency

Asset prices fully reflect all of the public and inside information available. Therefore, no one
can have an advantage in the market in predicting prices since there is no data that would
provide any additional value to the investors.

Active and Passive Investing

If you’re a passive investor, you invest for the long haul. Passive investors limit the amount
of buying and selling within their portfolios, making this a very cost-effective way to invest.
The strategy requires a buy-and-hold mentality. That means resisting the temptation to react
or anticipate the stock market’s every next move.

What is the 'Random Walk Theory'

1. The random walk theory suggests that changes in stock prices have the same distribution and
are independent of each other, therefore, the past movement or trend of a stock price or
market cannot be used to predict its future movement. In short, this is the idea that stocks take
a random and unpredictable path.
2. A proponent of the random walk theory believes it's impossible to outperform the market
without assuming additional risk. Critics of the theory, however, contend that stocks do maintain
price trends over time – in other words, that it is possible to outperform the market by carefully
selecting entry and exit points for equity investments.

What is 'Intrinsic Value'

Intrinsic value is the perceived or calculated value of a company, including tangible and
intangible factors, using fundamental analysis. Also called the true value, the intrinsic value
may or may not be the same as the current market value. Additionally, intrinsic value is also
used in options pricing to indicate the amount that an option is "in the money."
Intrinsic value can be calculated by value investors using fundamental analysis to look at both
qualitative (business model, governance, and target market factors) and quantitative (ratios and
financial statement analysis) aspects of a business. This calculated value is then compared to the
market value to determine whether the business or asset is over- or undervalued.

What is an efficient market?

 Efficient market is one where the market price is an unbiased estimate of the true
value of the investment.
 Implicit in this derivation are several key concepts -

(a) Market efficiency does not require that the market price be equal to true value at
every point in time. All it requires is that errors in the market price be unbiased, i.e., that
prices can be greater than or less than true value, as long as these deviations are random.

(b) The fact that the deviations from true value are random implies, in a rough sense, that
there is an equal chance that stocks are under or over valued at any point in time, and
that these deviations are uncorrelated with any observable variable. For instance, in an
efficient market, stocks with lower PE ratios should be no more or less likely to under valued
than stocks with high PE ratios.

(c) If the deviations of market price from true value are random, it follows that no group of
investors should be able to consistently find under or over valued stocks using any
investment strategy.

- Under weak form efficiency, the current price reflects the information contained in all past
prices, suggesting that charts and technical analyses that use past prices alone would not be
useful in finding under valued stocks.

- Under semi-strong form efficiency, the current price reflects the information contained not
only in past prices but all public information (including financial statements and news
reports) and no approach that was predicated on using and massaging this information would
be useful in finding under valued stocks.

- Under strong form efficiency, the current price reflects all information, public as well as
private, and no investors will be able to consistently find under valued stocks.

What market efficiency does not imply:

An efficient market does not imply that -

(a) stock prices cannot deviate from true value; in fact, there can be large deviations from
true value. The only requirement is that the deviations be random.

(b) no investor will 'beat' the market in any time period. To the contrary, approximately
half of all investors, prior to transactions costs, should beat the market in any period.

(c) no group of investors will beat the market in the long term. Given the number of
investors in financial markets, the laws of probability would suggest that a fairly large
number are going to beat the market consistently over long periods, not because of their
investment strategies but because they are lucky. It would not, however, be consistent if a
disproportionately large number of these investors used the same investment strategy.

Dirty price

The price of a bond is the present value of its future cash-flows. To avoid the impact of the
next coupon payment on the price of a bond, this cash flow is excluded from the price of the
bond and is called the accrued interest. In finance, the dirty price is the price of a bond
including any interest that has accrued since issue of the most recent coupon payment. This is
to be compared with the clean price, which is the price of a bond excluding the accrued
interest.

Dirty Price = Clean Price + Accrued Interest

Bond Pricing Example

Term Value
Par value 1,000.00
Total amount at settlement $985.50
Dirty price $985.50
Accrued interest $2.00
Market value less accrued interest $983.50
Clean price $983.50
What is the 'Dirty Price'

A dirty price is a bond pricing quote referring to the price of a coupon bond that includes the
present value of all future cash flows, including interest accruing on the next coupon
payment. The dirty price is how the bond is quoted in most European markets, and it is the
price an investor pays to acquire the bond.

Accrued interest is earned when a coupon bond is currently in between coupon payment
dates. As the next coupon payment date approaches, the accrued interest increases until the
coupon is paid. Immediately following the coupon payment, the clean price and dirty price
will be equal.

The dirty price is sometimes called the price plus accrued. The clean price is quoted more
often in the United States.

The dirty price allows a seller to compensate for the fact that known accrued interest
payments will be redirected to the buyer. This helps the seller get as much as possible out of
the investment prior to releasing it to the buyer, and it provides flexibility in regards to the
exact date of the sale. Otherwise, buyers may learn to time to purchase to gather the largest
amount of accrued interest, essentially short-changing the seller, which could lead sellers to
limit the days the bond could be for sale.
Accrued Interest

Since interest accrues at a steady rate on a bond, the amount earned can be calculated on a
daily basis. This means that the dirty price will change daily until the payout, or coupon
payment, date. Once the payout is complete, and the accrued interest resets to zero, the dirty
and clean price are the same.

In the case of bonds offering semi-annual payments, the dirty price would rise slightly higher
every day over the course of six months. Once the six-month mark is hit and the coupon
payment is made, the accrued interest resets to zero to begin the cycle again. This continues
until the bond reaches maturity.

Dirty Versus Clean Pricing

The dirty price is generally quoted between brokers and investors, which is common in some
markets. The clean price, or the price of the bond without accounting for accrued interest, is
often considered the published price. This may be the amount that would be recorded in a
newspaper or another financial resource used for price tracking, and it is often considered to
reflect the value of the bond within the current marketplace. The clean price may also be
known as the flat price.

What is a 'Bollinger Band®'

A Bollinger Band®, is plotted two standard deviations away from a simple moving average.

In this example of Bollinger Bands®, the price of the stock

is bracketed by an upper and lower band along with a 21-
day simple moving average. Because standard deviation is
a measure of volatility, when the markets become more
volatile, the bands widen; during less volatile periods, the
bands contract. Many traders believe the closer the prices
move to the upper band, the more overbought the
market, and the closer the prices move to the lower band,
the more oversold the market.

The Squeeze

The squeeze is the central concept of Bollinger Bands®. When the bands come close
together, constricting the moving average, it is called a squeeze. A squeeze signals a period of
low volatility and is considered by traders to be a potential sign of future increased volatility
and possible trading opportunities.

Conversely, the wider apart the bands move, the more likely the chance of a decrease in
volatility and the greater the possibility of exiting a trade. However, these conditions are not
trading signals. The bands give no indication when the change may take place or which
direction price could move. The bottom line is that Bollinger Bands® are designed to
discover opportunities that give investors a higher probability of success.
Bollinger Bands display a graphical band and volatility (expressed by the width of the envelope) in
one two-dimensional chart. The purpose of Bollinger Bands is to provide a relative definition of high
and low prices of a market. By definition, prices are high at the upper band and low at the lower
band. This definition can aid in rigorous pattern recognition and is useful in comparing price action
to the action of indicators to arrive at systematic trading decisions.

When the bands lie close together, a period of low volatility is indicated.[5] Conversely, as the bands
expand, an increase in price action/market volatility is indicated.[5]

When the bands have only a slight slope and track approximately parallel for an extended time, the
price will generally be found to oscillate between the bands as though in a channel.

What is the 'Money Flow Index - MFI'

1. The money flow index (MFI) is a momentum indicator that measures the inflow and
outflow of money into a security over a specific period of time.
2. The MFI uses a stock's price and volume to measure trading pressure. Because the MFI
adds trading volume to the relative strength index (RSI), it's sometimes referred to as
volume-weighted RSI.
3. Many traders watch for opportunities that arise when the MFI moves in the opposite direction
as the price. This divergence can often be a leading indicator of a change in the current trend.
4. An MFI of over 80 suggests the security is overbought, while a value lower than 20 suggest the
security is oversold.

What is the 'Relative Strength Index - RSI'

1. The Relative Strength Index - RSI is a momentum indicator that measures the magnitude
of recent price changes to analyze overbought or oversold conditions. It is primarily used
to attempt to identify overbought or oversold conditions in the trading of an asset.
2. The RSI provides a relative evaluation of the strength of a security's recent price
performance, thus making it a momentum indicator.
3. RSI values range from 0 to 100. The default time frame for comparing up periods to
down periods is 14, as in 14 trading days. Traditional interpretation and usage of the RSI
is that RSI values of 70 or above indicate that a security is becoming overbought or
overvalued, and therefore may be primed for a trend reversal or corrective pullback in
price.
4. On the other side of RSI values, an RSI reading of 30 or below is commonly interpreted
as indicating an oversold or undervalued condition that may signal a trend change or
corrective price reversal to the upside.

Moving Average Crossover

A crossover is the most basic type of signal and is favoured among many traders because it removes
all emotion. The most basic type of crossover is when the price of an asset moves from one side of a
moving average and closes on the other.

Price crossovers are used by traders to identify shifts in momentum and can be used as a basic entry
or exit strategy. As you can see in Figure 1, a cross below a moving average can signal the beginning
of a downtrend and would likely be used by traders as a signal to close out any existing long
positions.

Conversely, a close above a moving average from below may suggest the beginning of a new
uptrend.

What is a 'Moving Average - MA'

A moving average (MA) is a widely used indicator in technical analysis that helps smooth out
price action by filtering out the “noise” from random price fluctuations. It is a trend-
following, or lagging, indicator because it is based on past prices.

The two basic and commonly used moving averages are the simple moving average (SMA),
which is the simple average of a security over a defined number of time periods, and the
exponential moving average (EMA), which gives greater weight to more recent prices.

The most common applications of moving averages are to identify the trend direction, and to
determine support and resistance levels. While moving averages are useful enough on their
own, they also form the basis for other technical indicators such as the Moving Average
Convergence Divergence (MACD).

How to Use Moving Averages

1. Moving averages lag current price action because they are based on past prices; the longer
the time period for the moving average, the greater the lag. Thus, a 200-day MA will have
a much greater degree of lag than a 20-day MA because it contains prices for the past 200
days.
2. The length of the moving average to use depends on the trading objectives, with shorter
moving averages used for short-term trading and longer-term moving averages more
suited for long-term investors.
3. The 50-day and 200-day MAs are widely followed by investors and traders, with breaks
above and below this moving average considered to be important trading signals.
4. Moving averages also impart important trading signals on their own, or when two averages cross
over. A rising moving average indicates that the security is in an uptrend, while a declining
moving average indicates that it is in a downtrend.
5. Similarly, upward momentum is confirmed with a bullish crossover, which occurs when a short-
term moving average crosses above a longer-term moving average. Downward momentum is
confirmed with a bearish crossover, which occurs when a short-term moving average crosses
below a longer-term moving average.

What is the 'Moving Average Convergence Divergence - MACD'

Moving average convergence divergence (MACD) is a trend-following momentum indicator

that shows the relationship between two moving averages of prices. The MACD is calculated
by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. A nine-
day EMA of the MACD, called the "signal line", is then plotted on top of the MACD,
functioning as a trigger for buy and sell signals.
BREAKING DOWN 'Moving Average Convergence Divergence - MACD'

Moving average convergence divergence (MACD) indicators can be interpreted using three
different methods:

1. Crossovers - As shown in the chart above, when the MACD falls below the signal line, it
is a bearish signal, which indicates that it may be time to sell. Conversely, when the MACD
rises above the signal line, the indicator gives a bullish signal, which suggests that the price
of the asset is likely to experience upward momentum. Many traders wait for a confirmed
cross above the signal line before entering into a position to avoid getting "faked out" or
entering into a position too early, as shown by the first arrow.

2. Divergence - When the security price diverges from the MACD, it signals the end of the
current trend. For example, a stock price that is rising and a MACD indicator that is falling
could mean that the rally is about to end. Conversely, if a stock price is falling and the
MACD is rising, it could mean that a bullish reversal could occur in the near-term. Traders
often use divergence in conjunction with other technical indicators to find opportunities.

3. Dramatic Rise - When the MACD rises dramatically - that is, the shorter moving average
pulls away from the longer-term moving average - it is a signal that the security is overbought
and will soon return to normal levels. Traders will often combine this analysis with the
Relative Strength Index (RSI) or other technical indicators to verify overbought or oversold
conditions.

Traders also watch for a move above or below the zero line because this signals the position
of the short-term average relative to the long-term average. When the MACD is above zero,
the short-term average is above the long-term average, which signals upward momentum.
The opposite is true when the MACD is below zero. As you can see from the chart above, the
zero line often acts as an area of support and resistance for the indicator.
What is 'Crossover'

A crossover is the point on a stock chart when a security and an indicator intersect. Technical
analysts use crossovers to aid in forecasting the future movements in the price of a stock.

In most technical analysis models, a crossover is a signal to either buy or sell. On the chart
below, the stock falls below its 20-day moving average – a bearish sign.

An example of a crossover would be when the security line breaks through its 25-day moving
average, which may be a signal to buy the stock. Some of the indicators that use crossovers
are moving averages and Bollinger Bands.

Technical analysis utilizes crossovers to indicate general buy or sell signals on the underlying
financial instruments. Traders use crossovers with various technical indicators to track
turning points in price trends, momentum, volatility, money flow and sentiment. Moving
average crossovers trigger breakouts and breakdowns.

Moving Average Crossovers

When utilizing moving averages, crossovers can determine a change in the price trend. A
common trend reversal technique is utilizing a five-period simple moving average with a 15-
period simple moving average. When the five-period moving average forms a crossover
through the 15-period moving average, it signals a reversal in the trend and potentially the
start of a new opposite trend, which is called a breakout or a breakdown.

A five-period moving average crossing up through the 15-period moving average indicates a
price breakout that should form an uptrend, composed of higher highs and higher lows. A
five-period moving average crossover down through the 15-period moving averages signals a
price breakdown that should start a new downtrend, composed of lower highs and lower
lows.

The rule of thumb is that longer time frame periods result in stronger lasting signals. A daily
chart time period is stronger than a one-minute chart time period. The trade-off is that the
shorter time period crossovers give earlier signals, but have many more false signals. When
the daily 50-period moving average makes a crossover through the daily 200-period moving
average, this is often known as the death cross, which signals a major price trend reversal.
Stochastic Crossovers

The stochastic indicator measures the momentum of an underlying financial instrument. It

gauges the immediate overbought or oversold condition of the instrument, similar to a car
tachometer.

The stochastic indicator is composed of two oscillators; the %D stochastic is the lead while
the %d-slow is the laggard on a chart labelled from 0 to 100 bands.

When the stochastic moves above the 80 band, the stock (or whatever financial instrument) is
considered to be overbought. When the stochastic falls below the 20 band, the underlying is
considered oversold. A sell signal forms when the %D stochastic forms a crossover down
through the %D-slow under the 80 band. A buy signal triggers when the %D forms a
crossover through the %D-slow back up through the 20 band.

What is a 'Bid-Ask Spread'

A bid-ask spread is the amount by which the ask price exceeds the bid price for an asset in
the market. The bid-ask spread is essentially the difference between the highest price that a
buyer is willing to pay for an asset and the lowest price that a seller is willing to accept to sell
it.

BREAKING DOWN 'Bid-Ask Spread'

The bid-ask spread is a reflection of the supply and demand for a particular asset. The bids
represent the demand, and the asks represent the supply for the asset. The depth of the bids
and the asks can have a significant impact on the bid-ask spread, making it widen
significantly if one outweighs the other or if both are not robust. Market makers and traders
make money by exploiting the bid-ask spread and the depth of bids and asks to net the spread
difference.

For example, if the bid price for a stock is $19 and the ask price for the same stock is $20,
then the bid-ask spread for the stock in question is $1. The bid-ask spread can also be stated
in percentage terms; it is customarily calculated as a percentage of the lowest sell price or ask
price. For the stock in the example above, the bid-ask spread in percentage terms would be
calculated as $1 divided by $20 (the bid-ask spread divided by the lowest ask price) to yield a
bid-ask spread of 5% ($1 / $20 x 100). This spread would close if a potential buyer offered to
purchase the stock at a higher price or if a potential seller offered to sell the stock at a lower
price.

The Bid-Ask Spread's Relation to Liquidity

The size of the bid-ask spread from one asset to another differs mainly because of the
difference in liquidity of each asset. Certain markets are more liquid than others. For
example, currency is considered the most liquid asset in the world, and the bid-ask spread in
the currency market is one of the smallest (one-hundredth of a percent); in other words, the
spread can be measured in fractions of pennies. On the other hand, less liquid assets, such as
small-cap stocks, may have spreads that are equivalent to 1 to 2% of the asset's lowest ask
price.
Elements of the Bid-Ask Spread

Some of the key elements to the bid-ask spread include a highly liquid market for any
security in order to ensure an ideal exit point to book a profit. Secondly, there should be some
friction in the supply and demand for that security in order to create a wide spread. Traders
should use a limit order rather than a market order; meaning the trader should decide the
entry point so that he doesn’t miss the spread opportunity. There is a cost involved with the
bid-ask spread, as two trades are being conducted simultaneously. Finally, the bid-ask spread
trades can be done in most kinds of securities — the most popular being foreign exchange
and commodities.

Stock exchanges are set up to assist brokers and other specialists in coordinating bid and ask
prices. The bid price is the amount that a buyer is willing to pay for a particular security; the
ask price is the amount that a seller wants for that security - it is always a little higher than the
bid price. The difference between the bid and ask prices is what is called the bid-ask spread
and this difference represents a profit for the broker or specialist handling the transaction.

There are several factors that contribute to the difference between the bid and ask prices.

The most evident factor is a security's liquidity. This refers to the volume or amount of stocks
that are traded on a daily basis. Some stocks are traded regularly, while others are only traded
a few times a day. The stocks and indexes that have large trading volumes will have narrower
bid-ask spreads than those that are infrequently traded. When a stock has a low trading
volume, it is considered illiquid because it is not easily converted to cash. As a result, a
broker will require more compensation for handling the transaction, accounting for the larger
spread.

Another important aspect that affects the bid-ask spread is volatility. Volatility usually
increases during periods of rapid market decline or advancement. At these times, the bid-ask
spread is much wider because market makers want to take advantage of - and profit from -
the change. When securities are increasing in value, investors are willing to pay more, giving
market makers the opportunity to charge higher premiums. When volatility is low and
uncertainty and risk are at a minimum, the bid-ask spread is narrow.

A stock's price also influences the bid-ask spread. If the price is low, the bid-ask spread will
tend to be larger. The reason for this is linked to the idea of liquidity. Most low-priced
securities are either new or are small in size. Therefore, the number of these securities that
can be traded is limited, making the them less liquid.

The bid-ask spread can say a lot about a security and, therefore, you should be aware of all
the reasons that are contributing to the bid-ask spread of a security you are following. Your
investment strategy and the amount of risk that you are willing to take on may affect what
bid-ask spread you find acceptable.
Spread and Trading Costs

When you pull up quotes for a currency pair, you will typically see two prices -- for example,
EUR/USD 1.11 - 1.12. This means that you can immediately buy one euro for $1.12 or sell
one euro for $1.11. The spread is the difference between these two prices and in this case is 1
cent. The spread is the cost you'll incur if you buy and then sell at the prevailing prices.
Starting with $1.12, you can buy one euro, but if you then sell it you may expect only $1.11,
resulting in a net loss of 1 cent.

Trading Volume

A broad rule that applies to all financial instruments is that the higher the trading volume, the
lower the bid-ask spread. This is because a higher volume means more buyers and sellers,
which increases the probability of finding willing buyers and sellers at any given time. The
more eager buyers are to purchase, the higher the prices they will offer. The more eager the
sellers are to unload a currency, the lower the prices they will accept. Hence, in a market with
plentiful buying and selling volume, bids will rise, asks will drop, and -- consequently -- the
spread will narrow.

Uncertainty

During times of high risk and uncertainty, the spread tends to widen. If, for example, the
outcome of elections and therefore the future economic policies in the United Kingdom
formed a big question mark, the spread in dollar vs. British pound sterling trading would be
likely to go up. This is because traders dislike risky situations and scale back trading activity
until the dust settles. With fewer active traders in the market, the spread will widen. While
broader spreads mean higher trading costs, uncertain times also offer significant profit
opportunities for investors who can successfully forecast future events.

Presence of Dealers

In addition to traders who buy and sell to profit from fluctuations in foreign exchange rates,
some institutions, usually large banks, act as dealers in the foreign currency markets. These
dealers make money mostly as a result of the spread, as they intend to sell at the ask price and
buy at the bid, thereby making profits without holding on to any currency for too long. The
more such dealers there are in the market, the lower the spread. Think of the spread as the
profit margin of dealers. As more dealers compete for the funds of traders, competition will
squeeze the margins and reduce the spreads.

What is 'Arbitrage'

Arbitrage is the simultaneous purchase and sale of an asset to profit from an imbalance in the
price. It is a trade that profits by exploiting the price differences of identical or similar
financial instruments on different markets or in different forms. Arbitrage exists as a result of
market inefficiencies and would therefore not exist if all markets were perfectly efficient.

Arbitrage occurs when a security is purchased in one market and simultaneously sold in
another market at a higher price, thus considered to be risk-free profit for the trader.
Arbitrage provides a mechanism to ensure prices do not deviate substantially from fair value
for long periods of time. With advancements in technology, it has become extremely difficult
to profit from pricing errors in the market. Many traders have computerized trading systems
set to monitor fluctuations in similar financial instruments. Any inefficient pricing setups are
usually acted upon quickly, and the opportunity is often eliminated in a matter of seconds.
Arbitrage is a necessary force in the financial marketplace.

What are 'Transaction Costs'

Transaction costs are expenses incurred when buying or selling a good or service.
Transaction costs represent the labor required to bring a good or service to market, giving rise
to entire industries dedicated to facilitating exchanges. In a financial sense, transaction costs
include brokers' commissions and spreads, which are the differences between the price the
dealer paid for a security and the price the buyer pays.

BREAKING DOWN 'Transaction Costs'

The transaction costs to buyers and sellers are the payments that banks and brokers receive
for their roles. There are also transaction costs in buying and selling real estate, which include
the agent's commission and closing costs, such as title search fees, appraisal fees and
government fees. Another type of transaction cost is the time and labor associated with
transporting goods or commodities across long distances.

Transaction costs are important to investors because they are one of the key determinants of
net returns. Transaction costs diminish returns, and over time, high transaction costs can
mean thousands of dollars lost from not just the costs themselves but because the costs reduce
the amount of capital available to invest. Fees, such as mutual fund expense ratios, have the
same effect. Different asset classes have different ranges of standard transaction costs and
fees. All else being equal, investors should select assets whose costs are at the low end of the
range for their types.

Elimination of Transaction Costs

When transaction costs diminish, an economy becomes more efficient, and more capital and
labor are freed to produce wealth. A shift of this nature does not come without growing pains,
as the labor market must adjust to its new environment.

One type of transaction cost is a barrier to communication. When an otherwise perfectly-

matched seller and buyer have absolutely zero means of communication, the transaction costs
of a deal are too high to be overcome. A bank serves the role of middleman by connecting
savings with investments and a prosperous economy justifies the income of the bank for the
transaction cost of compiling information and linking parties.

However, the Age of Information, specifically the influx of the internet and
telecommunications, has greatly reduced barriers to communication. Consumers no longer
need large institutions and their agents to make educated purchases. For this reason, the
survival of the insurance agent is being jeopardized by a wide range of technology start-ups
that run websites either selling or promoting insurance policies. The easy access to
information and communication that the internet provides has also threatened the livelihood
of jobs, such as the real estate agent, stock broker and car salesman.
In essence, the prices of many goods and services have lowered due to a reduction in barriers
to communication between everyday men and women. Retailers and merchandisers serve the
role of middlemen as well, by pairing consumers with manufacturers. The retailing industry
has also been shaken up in recent years, with e-commerce company Amazon.com passing
traditional giants such as Kohl's and Macy's in a composite score based on assets, revenues
and market value.

Mutual Fund Transaction Costs

The average annual transaction cost for a mutual fund in the U.S. was 1.44%, according to a
study by Edelen, Evans and Kadlec. The first of these costs is brokerage commissions from
when a fund manager buys or sells a stock. Lower-turnover funds will pay less brokers' fees,
though they may pay more than individual investor. A large mutual fund may also incur
market impact costs, where the fund's sizable purchase of stock artificially drives the price
higher. Some managers diminish these costs by spreading their purchases over longer periods
of time. Last, the mutual fund will encounter spread costs, which can be greater when the
manager trades stocks across global exchanges or those with less liquidity.

What is a 'Swap'

A swap is a derivative contract through which two parties exchange financial instruments.
These instruments can be almost anything, but most swaps involve cash flows based on a
notional principal amount that both parties agree to. Usually, the principal does not change
hands. Each cash flow comprises of one leg of the swap. One cash flow is generally fixed,
while the other is variable, that is, based on a a benchmark interest rate, floating currency
exchange rate, or index price.

The most common kind of swap is an interest rate swap. Swaps do not trade on exchanges,
and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter
contracts between businesses or financial institutions.

Interest Rate Swaps

In an interest rate swap, the parties exchange cash flows based on a notional principal amount
(this amount is not actually exchanged) in order to hedge against interest rate risk or to
speculate. For example, say ABC Co. has just issued $1 million in five-year bonds with a
variable annual interest rate defined as the London Interbank Offered Rate (LIBOR) plus
1.3% (or 130 basis points). LIBOR is at 1.7%, low for its historical range, so ABC
management is anxious about an interest rate rise.

They find another company, XYZ Inc., that is willing to pay ABC an annual rate of LIBOR
plus 1.3% on a notional principal of $1 million for 5 years. In other words, XYZ will fund
ABC's interest payments on its latest bond issue. In exchange, ABC pays XYZ a fixed annual
rate of 6% on a notional value of $1 million for five years. ABC benefits from the swap if
rates rise significantly over the next five years. XYZ benefits if rates fall, stay flat or rise only
gradually.

Below are two scenarios for this interest rate swap: 1) LIBOR rises 0.75% per year, and 2)
LIBOR rises 2% per year.
Scenario 1

If LIBOR rises by 0.75% per year, Company ABC's total interest payments to its bond
holders over the five-year period are $225,000. Let's break down the calculation. At year 1,
the interest rate will be 1.7%;

Year 2 = 1.7% + 0.75% = 2.45%

Year 3 = 2.45% + 0.75% = 3.2%

Year 4 = 3.2% + 0.75% = 3.95%

Year 5 = 3.95% + 0.75% = 4.7%

$225,000 = $1,000,000 x [(5 x 0.013) + 0.017 + 0.0245 + 0.032 + 0.0395 + 0.047]

In other words, $75,000 more than the $150,000 that ABC would have paid if LIBOR had
remained flat:

$150,000 = $1,000,000 x 5 x (0.013 + 0.017)

ABC pays XYZ $300,000:

$300,000 = $1,000,000 x 5 x 0.06

and receives $225,000 in return (the same as ABC's interest payments to bond holders).
ABC's net loss on the swap comes to $300,000 - $225,000 = $75,000.

Scenario 2

In the second scenario, LIBOR rises by 2% a year. Therefore, Year 1 interest payments rate is
1.7%;

Year 2 = 1.7% + 2% = 3.7%

Year 3 = 3.7% + 2% = 5.7%

Year 4 = 5.7% + 2% = 7.7%

Year 5 = 7.7% + 2% = 9.7%

This brings ABC's total interest payments to bond holders to $350,000

$350,000 = $1,000,000 x [(5 x 0.013) + 0.017 + 0.037 + 0.057 + 0.077 + 0.097]

XYZ pays this amount to ABC, and ABC pays XYZ $300,000 in return. ABC's net gain on
the swap is $50,000.

Note than in most cases, the two parties would act through a bank or other intermediary,
which would take a cut of the swap. Whether it is advantageous for two entities to enter into
an interest rate swap depends on their comparative advantage in fixed or floating rate lending
markets.

Other Swaps:

The instruments exchanged in a swap do not have to be interest payments. Countless varieties
of exotic swap agreements exist, but relatively common arrangements include commodity
swaps, currency swaps, debt swaps, and total return swaps.

Commodity swaps: Commodity swaps involve the exchange of a floating commodity price,
such as the Brent Crude oil spot price, for a set price over an agreed-upon period. As this
example suggests, commodity swaps most commonly involve crude oil.

Currency swaps: In a currency swap, the parties exchange interest and principal payments
on debt denominated in different currencies. Unlike an interest rate swap, the principal is not
a notional amount, but is exchanged along with interest obligations. Currency swaps can take
place between countries, for example, China has entered into a swap with Argentina, helping
the latter stabilize its foreign reserves.

Debt-equity swaps: A debt-equity swap involves the exchange of debt for equity; in the case
of a publicly traded company, this would mean bonds for stocks. It is a way for companies to
refinance their debt or re-allocate their capital structure.

Total return swaps: In a total return swap, the total return from an asset is exchanged for a
fixed interest rate. This gives the party paying the fixed rate exposure to the underlying
asset—a stock or an index for example—without having to expend the capital to hold it.