What does the bid-ask spread represent in financial markets?

The bid-ask spread represents the difference between the buying price (the ask price) and the selling price (the bid price) of a security in financial markets. This spread is a crucial indicator of market liquidity; a narrower spread typically signifies a more liquid market where there are plenty of buyers and sellers, while a wider spread indicates less liquidity. Traders and investors pay attention to the bid-ask spread as it reflects the cost of entering and exiting a position in a security.

In this context, the total transaction cost of purchasing relates to various fees and costs in a transaction beyond just the bid-ask spread, such as commissions, which are not captured by the spread alone. The average market price does not adequately represent the dynamics of buying and selling since it does not account for the specific prices at which transactions occur. The liquidity risk premium refers to compensation that investors require for the risk associated with investing in assets that may not be easily sold, which is also distinct from the bid-ask spread.