The spread between the bid price and the ask price quoted by a dealer is a measure of which type of risk?
The correct answer and explanation is:
Correct Answer: Liquidity Risk
Explanation (300 words):
The spread between the bid price and the ask price quoted by a dealer is a direct measure of liquidity risk in a financial market.
In financial markets, the bid price is the maximum price a buyer is willing to pay for a security, while the ask price (or offer price) is the minimum price a seller is willing to accept. The difference between the ask and bid price is known as the bid-ask spread.
A narrow bid-ask spread usually indicates a liquid market, where there are many buyers and sellers actively trading, making it easy to enter or exit positions with minimal cost. On the other hand, a wide bid-ask spread reflects a less liquid or illiquid market, where fewer participants are available, and transaction costs are higher. This wider spread represents a form of liquidity risk — the risk that an investor cannot buy or sell an asset quickly enough, or at a favorable price, due to limited market activity.
Dealers often set wider spreads when they perceive uncertainty or limited interest in a security, thereby compensating themselves for the risk of holding an asset that might be difficult to resell. Additionally, during volatile market conditions or for thinly traded securities, spreads widen further to reflect the added risk.
Importantly, liquidity risk differs from other financial risks such as credit risk (the risk a counterparty won’t fulfill obligations) or market risk (the risk of asset value changing due to market movements). While those are also crucial, they are not directly reflected in the bid-ask spread.
In summary, the bid-ask spread serves as a practical indicator of liquidity risk, revealing how easily and cheaply a security can be traded in the market. The wider the spread, the greater the liquidity risk.