Understanding bid-offer spreads in OTC markets

Bid-offer spreads are traditionally explained by inventory costs, operating expenses and dealers’ risk of transacting with better-informed clients. In OTC (over-the-counter) markets, however, client knowledge and market power of dealers gives rise to price discrimination in favor of clients with high volumes and sophistication. Institutional investment strategies in forwards, swaps and options that are sensitive to transaction cost must consider the institution’s standing with their market makers.