What is Spot Price?
A spot price is the current market price of a commodity, financial product, or derivative product. An investor or trader can buy or sell the given asset or security for immediate delivery at this same price. To own safety, a buyer needs to pay the spot price right now, and the seller should deliver the security at that very moment. A spot price is defined by the number of buyers and sellers interested in trading in that security, commonly referred to as depth.
- There is no mathematical formula for spot price. It is more of an economic concept rather than a mathematical part. At any point in time, forces of demand and supply play an essential role in determining the market price. For accounting purposes, this will be reasonably uniform worldwide. It is very different from futures or forwards contracts because those are agreed-upon prices based on some deal.
- It is the reference or starting point for pricing many financial products. The spot price is added with the storage and other tangible costs for commodities. On the other hand, for financial products like futures – the spot price is added with the carry cost of that product based on the prevailing interest-free rate. There will be other factors involved, like the credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection. and market risk, but the price is most often the reference point for all this analysis.
Example of Spot Price
Consider the example of the stock price of Alphabet, Inc., which is quoted at $1,200. It means that a trader interested in this stock needs to spend $1,200 to own it right now. As soon as the trader does so, they will transfer Alphabet shares to their account within two days.
Contract details will be recorded and will initiate the trade at that very moment. There is also another way the trader can get these shares by buying the futures contract, which will be different depending on expiry.
As per contract, a pre-decided quantity will be transferred to the trader’s account at the expiry date. When the trader pays a certain amount and gets instant delivery, it refers to the spot price. And the latter relates to the future price.
As shown above, the market prices change with time. It varies with time and depends on the number of buyers and sellers. When there are more buyers, the price will rise, and when sellers are more, the spot will start decreasing. So can say that the spot price trend reflects market participant behavior.
Spot Price – Contango and Backwardation
Traders use the spot price to determine the security trend or the financial product. It is done by analyzing the current price, the future price, and the difference called a basis. Under normal circumstances, one would assume that the future cost would be greater than the spot price. It is because leaving all factors aside is the time value of moneyTime Value Of MoneyThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment.. Simply because there is always a positive risk free rateRisk Free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk. that should be added to the spot price to derive other expenses. When the future price is greater than the spot price, this scenario is known as ContangoContangoContango describes a situation in which the future price of a commodity or security (also known as the Futures Price) is higher than the current price (known as Spot Price)..
On the other hand, BackwardationBackwardationBackwardation is a situation when the futures price of a commodity is lower than the spot price today. It is a rare situation and doesn't last long. However, the commodity's spot price can be high due to the sudden rise in demand or a disaster triggering the demand. is the scenario when the future price is less than the spot price. Eventually, both the prices will converge on the expiry date. The former gives an optimistic picture of the security while the latter denotes that the security price is going south. Traders will look to short the security in such a scenario.
Spot Price and Arbitrage
The spot price for all accounting and calculation purposes is uniform worldwide. However, there can be times when these prices differ. For example, the stock price of Google’s parent companyParent CompanyA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary's directions and policies. – Alphabet, is different at NYSE and NASDAQ. Though unexpected, if such a scenario arises, traders will take full advantage of the same. They will remain long where the stock quoting is low and short where it is priced higher.
As soon as more traders try doing that, the price at both exchanges will converge and eventually match each other. This situation is called arbitrage, and such opportunities are pure gold for traders, which they would never want to miss. In fact, because of the trader on the lookout for arbitrage, such opportunities either do not exist or exist for a very short duration. Thus eventually making the financial marketsFinancial MarketsThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces. much more efficient.
The spot price reflects how things are perceived in the market for that particular security. It can be checked through depth and gives an account of the number of buyers and sellers at a specific period.
For any commodity, security, or any other type of financial product, the spot price is of utmost importance and primary number. Any additional price or different calculation must be done, keeping the current price as the reference. Be it the commodity cost of carrying or futures contract price three months down the line, it has to start from somewhere, and that starting point is called a spot price.
Further, it can be studied to identify the market trend, identify arbitrage opportunities, or any other derivative pricing. Most often than not, traders across the planet analyze the bond’s spot prices, not only the current ones but also for 3-4 years down the line to identify the trend and supposedly predict a recession.
It is a guide to what Spot Price is and its definition. Here we discuss the meaning of spot price along with examples and explanations. You can learn more from the following finance articles –