A spread is a difference between two prices or yields. Bid-ask spreads reflect that the most competitive buyers and sellers want to trade an asset at different prices. Yield spreads reflect a difference in bond tenors, credits, liquidity, optionality, or other features. Option spreads reflect views on prices beyond just positive or negative. Commodity spreads reflect time evolution of supply or demand or the gross producer margin for creating a product.
A spread is a difference between two prices or yields. The most common spreads in finance are bid-ask spreads, yield spreads, option spreads, and commodity spreads.
Bid-Ask Spreads
Bid-ask spreads reflect that the most competitive buyers and sellers want to trade an asset at different prices. This spread arises for a number of reasons: intermediaries needing to make a profit to counteract the risk of adverse selection, buyers and sellers whose orders match being eliminated from the order book, and intermediaries and investors needing a better price to diverge from what they might otherwise hold. For more information on bid-ask spreads, readers should consult Hasbrouck's Empirical Market Microstructure or Foucault, Pagano, and Röell's Market Liquidity.
Yield Spreads
Yield spreads reflect a difference in bond yields. The difference may be because the bonds are of different tenors, e.g. a 30-year bond versus and overnight loan. The bonds might have different credit quality such as a 10Y US Treasury note versus a 10Y note issued by Yahoo. The bonds might have different liquidity, like the on-the-run (newly-issued) 30Y government bond versus the off-the-run (prior newly-issued) 30Y (or maybe now 28-year) government bond. The bonds might differ in optionality: perhaps one bond may be called (repaid) if interest rates drop below a certain level. Or, there may be other bond features that explain yield differences. For more information on yield spreads, readers should consult Fabozzi and Mann's Handbook of Fixed Income Securities, Homer et al's Inside the Yield Book, or Veronesi's Fixed Income Securities.
Option Spreads
Option spreads reflect views on prices beyond just positive or negative -- which could be expressed by trading a call or put. Instead, one may combine calls and puts, sometimes at different expiries, to create a payoff that reflects a belief that prices will be volatile (a straddle or strangle), not be volatile (a butterfly or iron condor), have some upside (bull call or put spread), or have some downside (bear call or bear put spread). A calendar spread (e.g. buying a call or at one expiry and selling a call with the same strike price at a later expiry) can have a payoff similar to a butterfly -- though it may be tilted to have more exposure on the upside or downside. For more information on option spreads, readers should consult Hull's Options, Futures, and Other Derivatives or McDonald's Derivatives Markets.
Commodity Spreads
Commodity spreads reflect the physicality of the underlying goods and how they are transported, created, and used.
The location differential reflects that the price of a physical good in location A is not the same as the price for that good in location B; differing transport costs from producers lead to those costs differing. Furthermore, constraints on transport (*e.g. pipeline capacity) may limit the ability of supply in location A to satisfy demand in location B and lead to a location differential.
Supply and demand may vary seasonally for commodities which have certain harvest times. A calendar spread between futures of different expiries may reflect price differences for the old versus the newly-harvested crop. Some commodities are difficult to store without losing value (e.g. power, fattened livestock) and so differences in prices may reflect the cost of storage if inventory will be needed to meet demand in the future.
Some commodity spreads reflect the gross producer margin for creating a product. For example, a crushing mill may purchase soybeans; filter out stones and debris; crush those to get hulls (not so valuable), meal, and oil; and, then sell the meal and oil. The prices of the beans, meal, and oil are actively traded; and, there is a typical amount of meal and oil gained from crushing a quantity of beans. Therefore, we can compare the price of selling a quantity of meal and oil to the cost of buying beans to make that amount of meal and oil.
The spread between those amounts of meal and oil and the beans (aka "the crush") is the gross producer margin and reflects the costs of running a crushing mill. If the crush is high, people owning mills will buy beans and turn them into meal and oil; if the crush is low, expensive mills will shut down. Thus we may be able to use the crush to better estimate the profitability of crushing mills.
Similar gross producer margin spreads can be informative for estimating the profitability of refiners, smelters, ethanol producers, power generation, and more. For more information on commodity spreads, readers should consult Geman's Commodities and Commodity Derivatives.
