Chartered Financial Analyst (CFA) Practice Exam Level 2

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Prepare for the CFA Exam Level 2 with comprehensive quizzes and resources. Test your knowledge with challenging questions that reflect the exam format and content. Build confidence and achieve your career goals in finance!

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What does a wider bid-ask spread indicate about market liquidity?

The market is very liquid with tight spreads
The market has low liquidity and higher transaction costs
The market is efficient with equal buying and selling pressure
The market has unlimited liquidity for large transactions

The correct answer is: The market has low liquidity and higher transaction costs

A wider bid-ask spread is indicative of low market liquidity and can also signify higher transaction costs. In a liquid market, where there are many buyers and sellers actively participating, buyers and sellers are able to transact at prices that are very close to one another, resulting in tight spreads. Conversely, when liquidity is low, it implies there are fewer market participants looking to trade, which can cause a larger disparity between the buying price (bid) and the selling price (ask). This wider spread means that traders must be willing to pay more (through the ask price) to enter a position or accept less (through the bid price) to exit a position compared to a more liquid market. Therefore, the increased cost of trading due to the wider bid-ask spread translates into higher transaction costs for investors. Thus, a wider bid-ask spread is a strong indicator of low liquidity conditions in the market.