Nowadays, more and more businesses are going international, shopping from international sites has become easier, and traveling to foreign countries is a new trend, all thanks to the internet. But to protect your hard-earned money, you must also know the ins and outs of foreign exchange. Read this article to learn what the spot exchange rate is, how it works, and how it differs from the forward exchange rate.
What is a spot exchange rate?
The rate at which you can currently exchange one currency for another is a spot exchange rate. Simply put, it is the open market rate that you will have to pay to purchase another currency.
Generally, spot exchange rates are set through the foreign exchange market, where currency traders, institutions, and countries come together to trade. Before diving deeper into the spot exchange rate, you should know that the foreign exchange market is very liquid, with lakhs of money being traded daily. The most commonly traded currencies are US Dollar, Euro, Pound, Yen, and Candian Dollar.
How did the spot exchange rate work?
Now that you have understood the spot exchange rate let’s understand how it works. Consider you have entered into a foreign transaction, and the payment must be made immediately. In this case, you will have to pay the amount at the spot exchange rate.
On the date of the transaction, the two parties involved will agree that currency (A) will be exchanged for another currency (B) along with the rate at which the exchange will take place. Moreover, the parties involved will also finalize the settlement date and exchange bank information (if required). Usually, the settlement date for spot exchange is 2 business days after the transaction date (there are certain exceptions to this).
What if I have bought and sold foreign exchange multiple times?
Generally, speculators buy and sell foreign currency multiple times for the same date of settlement. In such a case, all your transactions will be netted off, and only the net gain/loss will be settled.
How to execute a spot exchange transaction?
Online trading has diversified foreign exchange, offering you a range of options for executing spot exchanges electronically. Some of the common methods used in executing these transactions are mentioned below.
1. Direct Execution
A spot exchange that 2 parties do without involving the 2nd party via telephonic communication or email, or any other mode of communication is known as direct execution.
2. Electronic Broking Systems
A broking platform that allows two parties to enter into a trade via an automated order matching system is known as an electronic broking system.
3. Electronic Trading Systems
This system uses software programs designed to ease the process of exchange. You can witness live market rates on this system, which will help you make your decisions. Here, you have two options – either you can execute a trade through a multibank dealing system or a single-bank trading platform.
4. Inter-dealer Voice Broker
When a spot exchange transaction is executed with a foreign exchange broker via telephonic conversation, it is known as an inter-dealer voice broker. Here, the broker is a financial intermediary whose job is to facilitate smooth investment transactions between two parties (parties can be an individual or an institution).
Factors determining the spot exchange rate
Below-mentioned are a few factors that determine the spot exchange rate.
1. Balance of Payments
Balance of payments represents the demand and supply of foreign exchange, which ultimately helps determine the value of the currency. So, when the demand for the currency is lesser than the supply, the balance of payment is said to be in deficit, thus resulting in a decline in its value. However, if the demand is higher, the currency gains its value.
Inflation in the country leads to an increase in the price of exports, because of which the demand for a currency decreases. In such a situation, the value of the currency also declines.
3. Capital Movements
If there is an increase in the interest rate in a country, short-term money flows in the country, resulting in an increased exchange rate of the currency. The reverse will happen in case of a decline in interest rate.
4. Money Supply
Increase in the money supply in the country leads to an increase in foreign investments and purchases. This results in an ample supply of currency in the foreign exchange markets, thus, reducing the value of the currency.
5. National Income
National income reflects the income of the residents of the country. When this income increases, the demand for goods in the country also increases. In such a situation, if the production doesn’t increase in line with the income, it leads to increased imports, thus, declining the currency’s value.
How is it different from the forward exchange rate?
The spot exchange rate is the rate at which the currency will be exchanged on the spot. While the forward exchange rate is the rate agreed upon now for a foreign exchange market transaction that is set to happen at a future date. In simple terms, the forward exchange rate is the future agreed exchange rate, and the spot rate is the immediate exchange rate of the currency.
Spot exchange rate is the rate at which you can exchange one currency with another. These exchange transactions are regulated and monitored by the foreign exchange market and are generally settled within 2 business days. Even though there are various factors such as political conditions, the balance of payment, interest rate, money supply, inflation, and more that influence these exchange rates, you must have a proper understanding of how currency is valued and why it is important. This will help you in making effective international investment decisions. If you want to start trading in foreign exchange, open a Demat account now.