In FX derivative market, why does vol spread of ATM > RR > BF? ATM is the most liquid and intuitively it should have the lowest spread. Please help me in understanding the rational behind the above logic.
The ATM is an outright position (long 50 delta put and 50 delta call) so the main exposure is vega. It is the riskiest of the three, and demands a higher bid-offer spread from market makers to compensate them for the additional risk.
The RR is a spread position (long 25 delta call, short 25 delta put) with zero vega, the main exposure is skew. Because the outright risk is hedged, market makers are willing to quote a tighter bid-offer spread.
The BF is a spread of spreads (long 25 delta call vs short 50 delta call, and long 25 delta put vs short 50 delta put) so it has no exposure to vega or skew. The main exposure is curvature. Hence it carries even lower risk than the ATM and RR, so market makers are willing to quote the lowest bid-offer spread.