What is the spot rate?
The price stated for the instantaneous settlement of a currency, commodity, interest rate, or security is known as the spot rate. The spot rate, often called the “spot price,” is the asset’s current market value at the time of the quotation that is available for prompt delivery. The amount that buyers are prepared to pay and the amount that sellers are willing to take determine this value based on a combination of variables, such as the present market value and the predicted future market value.
Spot prices are location- and time-specific, but in a global economy, most stocks or commodities’ spot prices tend to be relatively constant across the board after considering exchange rates. A futures price, sometimes called a forward price, is the agreed-upon price for the asset’s future delivery instead of the spot price.
Understanding Spot Rates
The needs of forex traders, people, and businesses looking to transact in foreign currencies determine the spot rate in currency exchange. From a foreign currency standpoint, other names for the spot rate include the “benchmark rate,” “straightforward rate,” and “outright rate.”
In addition to currencies, commodities (such as crude oil, regular gasoline, propane, cotton, gold, copper, coffee, wheat, and timber) and bonds are examples of assets with spot rates. The zero-coupon rate determines bond spot rates, but commodity spot prices are determined by supply and demand for these goods. Traders may get spot rate information from various sources, such as Thomson Reuters, Morningstar, and Bloomberg. The news often reports on these similar spot rates, especially those for currency pairings and commodity prices.
The Forward Rate and the Spot Rate
Spot settlement, or the money transfer that closes a spot contract, often happens one or two business days after the trading date, also known as the horizon. The day when settlement happens is known as the spot date. The transaction will be settled at the predetermined spot rate regardless of what transpires in the markets between when it is started and when it concludes.
Since the predicted future value of a commodity, security, or currency depends in part on its present value and in part on the risk-free rate and the period until the contract matures, the spot rate is used to calculate the forward rate or the price of a future financial transaction. If traders know the futures price, risk-free rate, and time to maturity, they may extrapolate an unknown spot rate.
The Connection Between Futures and Spot Prices
The pricing of futures contracts may change significantly from spot prices. Prices for futures may be in backwardation or contango. Futures prices fall to match the lower spot price in a contango. The rising futures price to match the higher spot price is backward. Since futures prices will climb to match the spot price as the contract approaches expiration, backwardation tends to favor net long holdings. Because the futures lose value as the contract nears expiration and converges with the lower spot price, contango is favorable to short positions.
Futures markets can transition between contango and backwardation and persist in either position for lengthy periods. Futures traders might benefit from examining both spot and futures pricing.
An Illustration of the Spot Rate Process
To illustrate how spot contracts operate, let’s imagine a wholesaler has to supply bananas in August. She will pay the seller the spot price and arrange for the bananas to be delivered in two days. However, because there is a high risk of spoilage, the wholesaler cannot make a spot purchase for this commodity if she needs the bananas to be available at its stores by the end of December but thinks the commodity will cost more during this winter due to higher demand and lower overall supply. A forward contract would be a better option for the banana investment since the product would be required in December.
An actual physical product is being taken for delivery in the situation above—futures and conventional contracts concerning the spot rate when signing is often used to carry out this transaction. Contrarily, traders often prefer to take positions on the spot rate for a particular commodity or currency pair using options and other instruments since they do not want to accept physical delivery.
Conclusion
- The market’s current supply and demand for an asset that can be delivered right away are reflected in the spot price.
- Futures prices are derived from and associated with the spot rates for specific currency pairings, commodities, and other assets.
- Delivery contracts often reference the spot rate in effect when signing.
