Written byA spread is the difference between two related rates or prices, such as a lender's rate and its benchmark, or an asset's buy and sell price.
Also known as: interest rate spread, bid-ask spread
Key points
- Spreads are quoted in percentage points or basis points, where 25 basis points means 0.25 per cent, not 2.5 per cent.
- On a loan, the spread is the lender's margin over its benchmark, covering funding costs, operating costs, credit losses and profit.
- In markets, the bid-ask spread is what it costs to get in and out, and it widens when liquidity thins.
- A credit spread is the extra yield a corporate bond pays over a government bond of similar maturity, compensating for credit risk.
Where you meet a spread
The bid-ask spread is the difference between the price someone will pay you for an asset and the price you pay to buy it. The interest-rate spread, or bank margin, is the lender's markup over a benchmark such as the cash rate or its own cost of funds. A credit spread is the extra yield demanded for corporate credit risk over government debt, and a yield spread is the general case: the gap between any two yields, such as two-year and 10-year government bonds.
You will also see swap spreads, the gap between swap rates and government bond yields at the same maturity, and FX pip spreads on currency pairs. The drivers differ, from liquidity to credit risk to funding costs, but every one of them measures how much extra sits between two related numbers, and each is anchored to a reference interest rate or price of some kind.
How a spread is calculated
The arithmetic is the easy part: subtract the lower number from the higher one. The units are where people trip up. One basis point is 0.01 per cent, so 100 basis points is one percentage point. To convert a percentage to basis points, multiply by 100; to go the other way, divide by 100.
A stock quoted 1.00 to 1.03 has a three cent spread, which is three per cent of the bid. A corporate bond yielding two percentage points more than a government bond of the same maturity has a credit spread of 200 basis points. For a loan, the effective rate is the reference rate plus the lender's margin, and the real cost adds the annualised fees on top of that.
Why it matters when you compare finance
Two lenders can advertise the same headline rate and still be charging very different margins over very different benchmarks, which changes how each will reprice when conditions move. When the Reserve Bank shifts the cash rate, lenders do not always pass the whole move through, because funding pressure and competition act on the margin. So ask what the benchmark is, what the margin over it is, and how often the rate is reviewed.
Then bring fees back in, since a spread is a rate difference and says nothing about them. A comparison rate bundles typical fees into one figure, which is a better basis for comparing total cost over a realistic term.
Example
A small-cap stock is quoted at $1.00 to sell and $1.03 to buy. The spread is three cents, or three per cent of the bid. Buy at $1.03 and sell straight back at $1.00 and you are down three cents a share before brokerage. A heavily traded blue chip might quote a spread of a fraction of a cent on the same dollar value. Same strategy, different result, purely because of the spread.
Not to be confused with
- Comparison rate
- a comparison rate bundles fees into a single rate, while a spread is only the gap between two rates
Frequently asked questions
What is a good spread?
It depends entirely on the market. Bid-ask spreads on liquid shares are tiny, while illiquid stocks and bonds can trade hundreds of basis points apart. On a loan, a smaller lender margin is better in isolation, but it only counts once you have compared the fees and the terms alongside it.
How many basis points is 0.75%?
Seventy-five. One basis point is 0.01 per cent, so multiply a percentage by 100 to get basis points and divide by 100 to go back. The common mistake is reading 25 basis points as 2.5 per cent when it actually means 0.25 per cent, a factor of ten.
Does spread include fees?
No. A spread is the difference between two rates or prices, and fees sit outside it. That is why a loan with a slim margin can still cost more than one with a wider margin. Compare using a rate that includes the typical fees, and check the assumptions behind it.
How do banks set their margin?
The margin has to cover what the money costs them, their operating expenses, the credit losses they expect, and a profit. Competition and prudential settings from APRA also shape it. That is why lenders respond differently to the same market conditions, and why margins move independently of the cash rate.
Are spreads fixed?
Rarely. Most spreads move with market liquidity, credit conditions and central bank signals. A bid-ask spread can widen within a day. A lender's margin can be repriced under the terms of your contract. Fixing a rate locks the spread for the fixed term, which is part of what you pay for.
Related terms
Margin
Margin is the share of each revenue dollar left after costs, what a lender adds to its base rate, or your own equity in a geared share portfolio.
Read definitionBasis point
A basis point (bps) is a unit equal to one hundredth of a percentage point, used to express small changes in interest rates, yields, fees and spreads.
Read definitionComparison rate
A comparison rate is a single annual percentage that combines a loan's interest rate with most upfront and ongoing fees to show its ongoing cost more clearly.
Read definitionInterest
Interest is the price of using money: what a borrower pays on a loan, or a saver earns on a deposit, expressed as a percentage rate on the principal.
Read definitionVariable rate
A variable rate is an interest rate that can move up or down over the life of a loan, following the lender's benchmark and its margin.
Read definitionFixed rate
A fixed rate is an interest rate locked in for a set term, so the rate and usually the repayments do not change until that term ends.
Read definitionGo deeper
Sources
This article is general information only and is not financial advice.