If volatility in foreign exchange markets, what is the relationship to the bid—ask spread?
What will be an ideal response?
ANSWER
Answer: The bid-ask spread compensates the bank’s trader for making a market in the two currencies. This requires that the trader hold an inventory of foreign currency, and an increase in volatility exposes the trader to potentially larger losses from a depreciation of the foreign currency against the domestic currency. Traders consequently try to protect themselves by increasing the bid-ask spread in more volatile markets.
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