What is the spot market?
Financial markets attract different types of participants. Some investors want instant delivery of securities while others get into contracts for delivery of shares at a future date. The immediate settlement of securities takes place in the spot market, also known as the cash market or liquid market. Ideally, the payment and the delivery of securities should take place immediately, but exchanges take time to process the transactions. Settlement on Indian stock exchanges takes T+2 days (process underway to become T+1), which is considered a spot transaction. The seller surrenders his/her holdings while the buyer pays the amount equivalent to the current market value of the securities. In the futures or ‘non-spot’ market, the price is decided in the present, but transfer of money and securities takes place on a future date. Sometimes, just before the expiry of futures contracts, futures trades become cash trades as the buyer and seller exchange money for the underlying asset immediately. The price of security decided in the spot market is known as the spot rate.
What is spot rate?
When it comes to currencies, securities, or commodities, the price that is quoted on them for immediate settlement of their trade is referred to as the spot rate or spot price of the commodity. Hence, the spot rate definition is that it is the current market value at the moment of the quote of a particular asset. The value of a spot rate is calibrated upon how much a buyer is willing to pay as well as how much a seller is willing to accept. This usually depends upon a slew of factors such as the current market price, as well as its expected future value.
To put it simply, when we define spot rate, it’s also necessary to add that it reflects the demand and supply for a certain asset in the market. Consequently, a security’s spot rate changes quite frequently and, in most cases, can even swing dramatically. It is often swayed by headlines regarding the asset or any significant events that affect investor sentiment, making it quite volatile.
Understand spot rates in different contexts
When it comes to the question of currency transactions, spot rate is swayed by the demands of businesses and individuals who are wishing to transact on forex or in a foreign currency. From a foreign exchange perspective, forex is also referred to as the outright rate, benchmark rate, or straightforward rate. Besides currencies, there are other assets that also have spot rates. These are commodities like gasoline, crude oil cotton, coffee, wheat, gold, lumber, and bonds, among others.
The spot rates for a commodity are based upon both demand and supply for these items. Bond spot rates, on the other hand, have a zero-coupon rate. There are a number of sources available to traders that provide spot rate information that traders can use to make strategic market moves. In fact, spot rate values, particularly those for commodity and currency prices are widely publicised in the news.
Spot Rate Example
As a spot rate example to understand how it works, say that it is the month of September, and the delivery of fruits needs to be made by a wholesaler. This wholesaler will pay the spot price to their seller so they can have the fruits delivered within two business days. Assume the wholesaler requires that the fruits become available in stores by late January, but also believes that by this point, the price of the fruits will be higher due to wintertime demand with lower supply. Now the wholesaler will not find it desirable to make a spot purchase for the commodity of fruits as the risk of spoilage of those fruits is higher.
After all, the fruits aren’t required until the end of January, so spot price does not seem to be of need. In this scenario, a forward contract fits much better. Hence, this is how spot prices and forward contracts are utilized in market transactions. In the aforementioned example, a physical commodity is actually being taken out for delivery. This kind of transaction is usually executed via a traditional or futures contract, which references the spot price at the time of it being signed.
On the other hand, there are many traders who generally do not want to take on the labor and risk associated with the physical delivery of a commodity. To counteract this risk, they use an options contract along with other such instruments, that give them positions on the spot rate of the particular currency pair or the commodity in question.
Spot Rate vs Forward Rate
Settling a spot rate is known as ‘spot settlement.’ It is defined as the transferral of funds thereby completing the spot contract’s transaction. It normally occurs around two days after the trading date. This is called its time horizon. The post date is the day of the settlement between the buyer and seller of the spot contract. Regardless of whatever happens in the market between the date of settlement and the date of the final transaction, the spot contract will be obeyed by both parties upon the agreed-upon spot rate.
This is why the spot rate is often used to determine what is called a ‘forward rate.’ The forward rate is the security’s price at their future financial transaction. Any security, commodity, or currency’s expected value in the future is based on both its current value, the risk-free rate, and the time until the spot contract will mature. Hence, with these three measures, available traders can extrapolate the spot rate of the security that is unbeknownst to them.
Relationship between spot price and futures price
- The spot price of an asset is the base with which the futures price of that asset is determined. Ascertaining the futures price of any asset is not possible without the spot price of that asset. Additionally, the futures price of an asset may either be equal to, lower than, or higher than the spot price of the same asset.
- When the futures price is equal to the spot price, such a situation is usually labeled as convergence. This typically happens on the date of expiry of a futures contract.
- When the futures price is lower than the spot price, the situation is labeled as backwardation. This is quite rare and doesn’t happen all the time.
- When the futures price is higher than the spot price, which is quite normal and happens most of the time, the situation is labeled as contango.
- Irrespective of whether the futures price is in contango or backwardation with the spot price, as the expiry of the futures contract approaches, both the prices would automatically converge.
Understanding Spot Trading
Now that we understand the spot transaction definition, the most common spot transactions are foreign exchange spot contracts which are usually delivered within two business days. Alternatively, many other financial instruments tend to settle by the following business day. Forex markets or ‘spot foreign exchange markets’ trade electronically globally. Forex is the world’s largest market. Over $5 million is traded on Forex daily. In comparison, interest rates as well as commodity markets are much smaller.
Spot trading contracts are commonly seen between a company and a financial institution, or between two financial institutions themselves. In an interest rate swap, the near leg is typically for the spot date and often settles in two trading days. Oftentimes, commodities are also traded on exchanges, with the most common commodities being traded on the CME group and the New York Stock Exchange. Commodity trading, often, is carried out for future settlement where it is not delivered, and the contract is resold back to its respective exchange prior to its maturity. The gain or loss from this exchange is settled in liquid funds.
Spot Market versus Over The Counter (OTC)
Spot markets like forex are publicly traded exchanges. However, centralised exchanges in the form of markets do not encapsulate all spot transactions ever. A spot transaction example can also be seen directly between buyer and seller. These are called over-the-counter spot trades. Unlike forex and other market trades, OTC transactions are decentralised.
In such transactions, the share price is either based on a future date/price or on the spot price. In an OTC transaction, the terms for the trade are not necessarily standardised. Hence, these transactions are usually subjected to the buyer’s and/or seller’s discretion. OTC stock transactions, similar to exchanges, are usually spot trades. Forward transactions or futures are often not spot transactions.
A spot rate is the price of a security when it is quoted by traders. It is constantly fluctuating with market developments. It can be used to determine the forward price of a security as well.