What Is the Spot Rate?
The spot rate is the price quoted for immediate settlement on an interest rate, commodity, a security, or a currency. The spot rate, also referred to as the "spot price," is the current market value of an asset available for immediate delivery at the moment of the quote. This value is in turn based on how much buyers are willing to pay and how much sellers are willing to accept, which usually depends on a blend of factors including current market value and expected future market value.
While spot prices are specific to both time and place, in a global economy the spot price of most securities or commodities tends to be fairly uniform worldwide when accounting for exchange rates. In contrast to the spot price, a futures or forward price is an agreed-upon price for future delivery of the asset.
- The spot rate reflects real-time market supply and demand for an asset available for immediate delivery.
- The spot rates for particular currency pairs, commodities, and other securities are used to determine futures prices and are correlated with them.
- Contracts for delivery will often reference the spot rate at the time of signing.
Understanding Spot Rates
In currency transactions, the spot rate is influenced by the demands of individuals and businesses wishing to transact in a foreign currency, as well as by forex traders. The spot rate from a foreign exchange perspective is also called the "benchmark rate," "straightforward rate" or "outright rate."
Besides currencies, assets that have spot rates include commodities (e.g., crude oil, conventional gasoline, propane, cotton, gold, copper, coffee, wheat, lumber) and bonds. Commodity spot rates are based on supply and demand for these items, while bond spot rates are based on the zero-coupon rate. A number of sources, including Bloomberg, Morningstar, and ThomsonReuters, provide spot rate information to traders. These same spot rates, particularly currency pairs and commodity prices, are widely publicized in the news.
The Spot Rate and the Forward Rate
Spot settlement (i.e., the transfer of funds that completes a spot contract transaction) normally occurs one or two business days from the trade date, also called the horizon. The spot date is the day when settlement occurs. Regardless of what happens in the markets between the date the transaction is initiated and the date it settles, the transaction will be completed at the agreed-upon spot rate.
The spot rate is used in determining a forward rate—the price of a future financial transaction—since a commodity, security, or currency’s expected future value is based in part on its current value and in part on the risk-free rate and the time until the contract matures. Traders can extrapolate an unknown spot rate if they know the futures price, risk-free rate, and time to maturity.
The Relationship Between Spot Prices and Futures Prices
The difference between spot prices and futures contract prices can be significant. Futures prices can be in contango or backwardation. Contango is when futures prices fall to meet the lower spot price. Backwardation is when futures prices rise to meet the higher spot price. Backwardation tends to favor net long positions since futures prices will rise to meet the spot price as the contract get closer to expiry. Contango favors short positions, as the futures lose value as the contract approaches expiry and converges with the lower spot price.
Futures markets can move from contango to backwardation, or vice versa, and may stay in either state for brief or extended periods of time. Looking at both spot prices and futures prices is beneficial to futures traders.
Example of How the Spot Rate Works
As an example of how spot contracts work, say it's the month of August and a wholesaler needs to make delivery of bananas, she will pay the spot price to the seller and have bananas delivered within 2 days. However, if the wholesaler needs the bananas to be available at its stores in late December, but believes the commodity will be more expensive during this winter period due to higher demand and lower overall supply, she cannot make a spot purchase for this commodity since the risk of spoilage is high. Since the commodity wouldn't be needed until December, a forward contract is a better fit for the banana investment.
In the example above, an actual physical commodity is being taken for delivery. This type of transaction is most commonly executed through futures and traditional contracts that reference the spot rate at the time of signing. Traders, on the other hand, generally don't want to take physical delivery, so they will use options and other instruments to take positions on the spot rate for a particular commodity or currency pair.