What is spot rate?
When it comes to currencies, securities, or commodities, there is a price that is quoted on them for immediate settlement of their trade. This is referred to as the spot rate or spot price of the commodity. Hence, the spot rate definition is that it is the current market value at the moment of the quote of a particular asset. The value of a spot rate is calibrated upon how much a buyer is willing to pay as well as how much a seller is willing to accept. This usually depends upon a slew of factors such as the current market price, as well as its expected future value.
To put it simply, when we define spot rate, it’s also necessary to add that it reflects the demand and supply for a certain asset in the market. Consequently, a security’s spot rate changes quite frequently and, in most cases, can even swing dramatically. It is often swayed by headlines regarding the asset or any significant events that affect investor sentiment, making it quite volatile.
Understand spot rate meaning
When it comes to the question of currency transactions, spot rate is swayed by the demands of businesses and individuals who are wishing to transact on forex or in a foreign currency. From a foreign exchange perspective, forex is also referred to as the outright rate, benchmark rate, or straightforward rate. Besides currencies, there are other assets that also have spot rates. These are commodities like gasoline, crude oil cotton, coffee, wheat, gold, lumber, and bonds, among others.
The spot rates for a commodity are based upon both demand and supply for these items. Bond spot rates, on the other hand, have a zero-coupon rate. There are a number of sources available to traders that provide spot rate information that traders can use to make strategic market moves. In fact, spot rate values, particularly those for commodity and currency prices are widely publicized in the news.
Spot Rate Example
As a spot rate example to understand how it works, say that it is the month of September, and the delivery of fruits needs to be made by a wholesaler. This wholesaler will pay the spot price to their seller so they can have the fruits delivered within two business days. Assume the wholesaler requires that the fruits become available in stores by late January, but also believes that by this point, the price of the fruits will be higher due to wintertime demand with lower supply. Now the wholesaler will not find it desirable to make a spot purchase for the commodity of fruits as the risk of spoilage of those fruits is higher.
After all, the fruits aren’t required until the end of January, so spot price does not seem to be of need. In this scenario, a forward contract fits much better. Hence, this is how spot prices and forward contracts are utilized in market transactions. In the aforementioned example, a physical commodity is actually being taken out for delivery. This kind of transaction is usually executed via a traditional or futures contract, which references the spot price at the time of it being signed.
On the other hand, there are many traders who generally do not want to take on the labor and risk associated with the physical delivery of a commodity. To counteract this risk, they use an options contract along with other such instruments, that give them positions on the spot rate of the particular currency pair or the commodity in question.
Spot Rate vs Forward Rate
Settling a spot rate is known as ‘spot settlement.’ It is defined as the transferral of funds thereby completing the spot contract’s transaction. It normally occurs around two days after the trading date. This is called its time horizon. The post date is the day of the settlement between the buyer and seller of the spot contract. Regardless of whatever happens in the market between the date of settlement and the date of the final transaction, the spot contract will be obeyed by both parties upon the agreed-upon spot rate.
This is why the spot rate is often used to determine what is called a ‘forward rate.’ The forward rate is the security’s price at their future financial transaction. Any security, commodity, or currency’s expected value in the future is based on both its current value, the risk-free rate, and the time until the spot contract will mature. Hence, with these three measures, available traders can extrapolate the spot rate of the security that is unbeknownst to them.
A spot rate is the price of a security when it is quoted by traders. It is constantly fluctuating with market developments. It can be used to determine the forward price of a security as well.