Chartered Financial Analyst (CFA) Practice Exam Level 2

In the context of financial instruments, what is the effect of large spreads on transaction costs?

1. They significantly lower transaction costs

2. They have no effect on transaction costs

3. They increase transaction costs due to reduced liquidity

4. They benefit smaller transactions at the expense of large ones

The correct answer is: They increase transaction costs due to reduced liquidity

Large spreads typically indicate a larger difference between the buying price and the selling price of a financial instrument. This situation generally reflects reduced market liquidity, as fewer participants may be willing to trade at those prices. As a result, when transaction spreads widen, the cost of executing trades increases because traders must navigate these larger price gaps. Specifically, buyers face higher costs when purchasing because they pay more than the midpoint price, while sellers receive less than the midpoint price when selling. Thus, larger spreads lead directly to increased transaction costs for investors, as they may have to accept worse pricing in order to execute their trades, ultimately impacting the efficiency of the trade execution process. Consequently, the connection between large spreads and increased transaction costs is grounded in the principles of market liquidity and pricing dynamics.