In forex, we often hear the term bid-ask spread or simply the “spread.” It is the difference that we get from the bid price and ask price. The bid price or bid is the highest price that a buyer can pay for an asset. On the other hand, the ask price or offer price is the lowest amount that a seller can accept for the asset being sold. In a forex trade, you would usually pay the higher amount to buy the currency and what you receive is usually the lower price if you are the one selling.
A money exchange scenario
To understand this further, let us cite an example of a typical daily scenario at an airport. Let us say that you are bound to Europe, and you did not have time to exchange your money before going to the airport. You want to exchange your USD for EUR. You are in a rush, so you decide to look at the exchange rate at the airport.
The board says: EUR 1= USD 1.10/ USD 1.30. Notice that there are two amounts. The higher amount is the price that you have to pay for 1 Euro.
Another person comes back from Europe. He wants to eat at the airport before heading home, but he did not have dollars nor cards with him, only Euro bills. So, he comes to the money exchanger and exchanges his Euros to USD. He receives the lower amount (USD 1.1).
What is the middle rate?
If we get the midpoint between the two prices in our previous scenario, we would have what we call the middle rate. This happens if both ends of the transaction are willing to meet in the middle and transact in the opposite directions simultaneously. This rate is significant when the market is not liquid enough, or the spread is too broad.
What is the formula?
The formula that we can use is: Middle rate = (Bid rate + Ask rate) ÷ 2
In this formula, we used the bid rate’s and ask rate’s median or midpoint. Thus, the midpoint goes between the spread that market makers offer.
Let us cite an example.
Let us assume that the EUR/ USD currency pair has a $1.111 bid and a $1.113 offer. The buyer and the seller are ready to transact with each other about the price where the buyer does not have to lift the offer, and the seller does not have to hit the bid. Hence they could agree with a middle rate where they can mutually benefit from the price and proceed to execution.
What now?
We have mentioned that the middle rate is essential in illiquid markets and wide spreads. Both parties meeting at a middle rate is somehow a rare situation already nowadays because trading has become so convenient. Anyone can do it online anytime and anywhere. Hence, the spread is always tight. The bid and offer are very close together. Also, forex with brokers are getting fewer; thus, middle rates become scarcer too.