Spot and Forward Rate

24/08/2020 1 By indiafreenotes

The precise meanings of the terms “forward rate” and “spot rate” are somewhat different in different markets. But what they have in common is that they refer, for example, to the current price or bond yield the spot rate versus the price or yield for the same product or instrument at some point in the future the forward rate.

In commodities futures markets, a spot rate is the price for a commodity being traded immediately, or “on the spot”. A forward rate is the settlement price of a transaction that will not take place until a predetermined date; it is forward-looking.

The precise meanings of the terms “forward rate” and “spot rate” are somewhat different in different markets. But what they have in common is that they refer, for example, to the current price or bond yield the spot rate versus the price or yield for the same product or instrument at some point in the future the forward rate.

In commodities futures markets, a spot rate is the price for a commodity being traded immediately, or “on the spot”. A forward rate is the settlement price of a transaction that will not take place until a predetermined date; it is forward-looking.

The Spot and Forward Rates in Commodities Markets

A spot rate, or spot price, represents a contracted price for the purchase or sale of a commodity, security, or currency for immediate delivery and payment on the spot date, which is normally one or two business days after the trade date. The spot rate is the current price quoted for immediate settlement of the contract.

For example, if during the month of August a wholesale company wants immediate delivery of orange juice, it will pay the spot price to the seller and have orange juice delivered within two days.

On the other hand, if the company needs orange juice to be available in late December, but believes the commodity will be more expensive during the winter period due to lower supply, it wouldn’t want to make a spot purchase since the risk of spoilage is high. A forward contract would a better fit for the investment. Unlike a spot transaction, a forward contract, involves an agreement of terms on the current date with the delivery and payment at a specified future date.

Spot and Forward Rates in Bond and Currency Markets

The terms spot rate and forward rate are applied a little differently in bond and currency markets. In bond markets, the price of an instrument depends on its yield that is, the return on a bond buyer’s investment as a function of time. If an investor buys a bond that is nearer to maturity, the forward rate on the bond will be higher than the interest rate on its face.

For example, if an investor buys a $1,000, two-year bond with a 10% interest rate, but buys it when there is only one year left until maturity, the yield or forward rate will actually be 21%, because he will be returned $1,210 in one year.

In currency markets, the spot rate, as in most markets, refers to the immediate exchange rate. The forward rate, on the other hand, refers to the future exchange rate agreed upon in forward contracts. For example, if a Chinese electronics manufacturer has a large order to be shipped to America in one year, and expects the U.S. dollar to be much weaker by that time, it might be able to transact a currency forward to lock in a more favorable exchange rate.

Spot and Forward Exchange Rates

Broadly speaking, we may distinguish between two types of exchange rates prevailing in the foreign exchange market viz., spot rate of exchange and forward rate of exchange. Spot rate of exchange and forward rate of exchange in terms of domestic money payable refers to the price of foreign exchange in terms of domestic money payable for the immediate delivery of a particular foreign currency.

It is, thus, a day-to-day rate. On the other hand, forward rate of exchange refers to the price at which a transaction will be consummated at some specified time in the future. A forward exchange market functions side by side with a spot exchange market.

The transactions of forward exchange market are known as forward exchange transactions, which simply involve purchase or sale of a foreign currency for delivery at some time in the future; the rates at which these transactions are consummated are, therefore, called forward rates.

Forward exchange rate is determined at the time of sale but the payment is not made until the exchange is delivered by the seller. Forward rates are usually quoted on the basis of a discount or premium over or under the spot rate of exchange.

Currency Swap

A sport of a currency when combined with a forward repurchase in a single transaction is called ‘currency swap.’ The swap rate is the difference between the spot and forward exchange rates in the currency swap.

Usually, a forex market is dominated by the spot markets transactions swaps and forward transactions.

Arbitrage

Arbitrage is the act of simultaneously buying a currency in one market and selling in another to make a profit by taking advantage of price or exchange rate differences in the two markets. If the arbitrage operations are confined to two markets only, they will be known as “two-point” arbitrage. If they extend to three or more markets, they are known as “three-point” arbitrage or “multipoint” arbitrage.