What is Spot Rate
Spot rate is the price quoted for immediate settlement on a commodity, a security or a currency. The spot rate, also called “spot price,” is based on the value of an asset 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 depends on factors such as current market value and expected future market value. As a result, spot rates change frequently and sometimes dramatically.
BREAKING DOWN Spot Rate
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 Thomson Reuters, provide spot rate information to traders.
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 also 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.
Function and Limitations of Spot Contracts
As an example of how spot contract works, say it's the month of August and a wholesaler needs to make delivery of bananas, it will pay the spot price to the seller and have bananas delivered within 2 days. However, if the buyer 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 a higher demand than supply, it 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.