The spot rate or spot price refers to an immediately agreed-upon value for a commodity, rate of interest, currency, or security. In other words, it is the present market value at the moment of the quote or sale. This is determined by the market forces of demand and supply, with variables like future predictions affecting the present value and vice-versa.
In this article, we will learn about the spot rate meaning and related concepts like forward rate and futures trading.
Spot rate meaning
One of the share market basics, the concept of spot rate can be understood, in the simplest of terms, as the ‘right now’ price. For example, if you are out shopping for gold, the price of gold at the time you purchase will be its spot price. This is also specific to the time of the purchase and the geographical location (as gold prices vary from one location to the other). However, with robust and interconnected global financial and economic systems, the variance in the prices is often not too high and fluctuates in a limited range. Although, this statement will only hold true after accounting for the currency exchange rates.
In the currency market, there are several factors influencing the spot rate, as it is determined by the requirements of buyers and sellers. In the context of the forex market, spot rate is also known as ‘benchmarking rate’, ‘outright rate’, or ‘straightforward rate’. In addition to the currency market, spot rates apply to commodities as well. These include crude oil, gold, silver, copper, wheat, gasoline, and cotton.
Spot rate stands in direct contrast to a futures contract, which is a contract to transact in the future at an agreed upon price. Let us take a look at the differences between the spot price, forward rate, and futures price.
Spot rate and forward rate
Settlements according to the spot rate are quick and seamless. They are typically settled in 24-48 business hours from the time of the trade. The date at which a trade is initiated is known as the ‘horizon’. And the date at which the payment clears and the transaction is completed is known as the spot date.
As spot prices represent the present value, they are also important in determining future value. One such metric of future value is the forward rate. The forward rate is a measure of the future value of the same transaction.
Let us assume that you want to purchase 500 kg of wheat and store it to sell in the future. You predict that the price of wheat will increase in the future but you do not have the storage to buy and store the wheat right now. To avoid paying more in the future, you can try to establish a contract with a favourable forward rate. This would ensure that you do not have to worry about storing the wheat for a long time and also protect you from fluctuations in future price levels.
Spot price and futures price
Now, let us understand what are futures. Future contracts are established to delay payments to a future date. The concept of futures prices is quite similar to the forward rate. However, a key difference here is that futures contracts are traded on the stock exchange. On the other hand, forward contracts are private and can be more flexible in their terms and conditions. Future contracts are more standardised compared to forward contracts. They are settled daily and have reduced chances of payment defaults.
Under the futures price system, if the spot price is less than the futures price, it is referred to as being in contango. For example, futures prices for commodities that are non-perishable are often in contango. On the flip side, perishable commodities are known to be in backwardation as their spot prices are often higher than the futures price.
For all smart investors and traders, it is important to study both the spot prices and the futures pricing to make logical and strategic bets in the market.
Example of the spot rate
To understand spot and future prices, let us go back to one of the examples mentioned above. If you are in the market for purchasing gold, you can simply make the purchase at the spot price, or the current market value. But, imagine for a moment that you want to buy a perishable commodity like apples. If you believe that the demand for apples is going to pick up in the next few months, which would also increase their market price, you can try to establish a future contract with a supplier. Future contracts will be a good way to mitigate the risks associated with the delayed settlement, like an increase in prices and not burden you with storing perishable goods.
Conclusion
The spot rate serves as the immediate measure of the current market value of commodities, currencies, or securities. It represents the 'right now' price determined by the interplay of demand and supply forces. Contrasting with futures contracts that enable transactions at agreed-upon prices and maturity dates in the future, the spot rate facilitates quick settlements within 2 business days. Understanding the dynamics between spot rates, forward rates, and futures prices empowers investors and traders to make informed decisions, whether in seizing present opportunities or hedging against future uncertainties.
