What Is the Spot Exchange Rate?
A spot exchange rate is the current price level in the market to directly exchange one currency for another, for delivery on the earliest possible value date. Cash delivery for spot currency transactions is usually the standard settlement date of two business days after the transaction date (T+2).
- The spot exchange rate is the current market price for changing one currency directly for another.
- Generally, the spot rate is set by the forex market, but some countries actively set or influence spot exchange rates through mechanisms like a currency peg.
- Currency traders follow spot rates to identify trading opportunities not only in the spot market but also in futures, forwards, or options markets.
Understanding the Spot Exchange Rate
The spot exchange rate is best thought of as how much you would have to pay in one currency to buy another at this moment in time. The spot exchange rate is usually decided through the global foreign exchange market where currency traders, institution and countries clear transactions and trades. The forex market is the largest and most liquid market in the world, with trillions of dollars changing hands daily. The most actively traded currencies are the U.S. dollar, the euro—which is used in many continental European countries including Germany, France, and Italy—the British pound, the Japanese yen and the Canadian dollar.
Trading takes place electronically around the world between large, multinational banks. Other active market participants include corporations, mutual funds, hedge funds, insurance companies and government entities. Transactions are for a wide range of purposes, including import and export payments, short- and long-term investments, loans and speculation.
Some currencies, especially in developing economies, are controlled by the government that sets the spot exchange rate. For instance, the central government of China sets a currency peg that keeps the Yuan within a tight trading range against the U.S. dollar.
Spot Exchange Rate Transactions
For most spot foreign exchange transactions, the settlement date is two business days after the transaction date. The most common exception to the rule is the U.S. dollar vs. the Canadian dollar, which settles on the next business day. Weekends and holidays mean that two business days is often far more than two calendar days, especially during the Christmas and Easter holiday season.
On the transaction date, the two parties involved in the transaction agree on the price, which is the number of units of currency A that will be exchanged for currency B. The parties also agree on the value of the transaction in both currencies and the settlement date. If both currencies are to be delivered, the parties also exchange bank information. Speculators often buy and sell multiple times for the same settlement date, in which case the transactions are netted and only the gain or loss is settled.
The Spot Market
The foreign exchange spot market can be very volatile. In the short term, rates are often driven by news, speculation and technical trading. In the long term, rates are generally driven by a combination of national economic fundamentals and interest rate differentials. Central banks sometimes intervene to smooth the market, either by buying or selling the local currency or by adjusting interest rates. Countries with large foreign currency reserves are much better positioned to influence their domestic currency's spot exchange rate.
How to Execute a Spot Exchange
There are a number of different ways in which traders can execute a spot exchange, especially with the advent of online trading systems. The exchange can be made directly between two parties, eliminating the need for a third party. Electronic broking systems may also be used, where dealers can make their trades through an automated order matching system. Traders can also use electronic trading systems through a single or multi-bank dealing system. Finally, trades can be made through a voice broker, or over the phone with a foreign exchange broker.