Spot Rate

Spot Rate Definition

“Spot Rate” is the cash rate at which immediate transaction and/or settlement takes place between the buyer and seller parties. This rate can be considered for any and all types of products prevalent in the market ranging from consumer products to real estate to capital markets. It gives the immediate value of the product being transacted.

Spot Rate Examples

Let’s see some simple to advanced examples to understand it better.

Spot Rate

Example #1

Joe goes to the market to purchase 10gm of 24k bullion gold. The seller bids the same at $450.00. This rate is the spot rate. If Joe buys the bullion at this rate, the transaction gets settled.

We can also say that this rate is the real market rate, which shows the actual market movement.

Example #2

In the above example, considers that the seller offers Joe with a deal. His view is that the market will be bullish in the future, and gold rates will rise. He suggests Joe book the bullion today at $455.00 and collect the same after one month. Rates after one month would be around $475.00.

This type of agreement is a forward contract whereby the buyer can book the product at a rate which is a little higher than the spot rate (including the seller’s premium), also called the forward rate, and take the delivery later, thus making profits from the then spot rate.

Example #3

It can be measured for Currency exchanges as well. Below is a table that demonstrates conversion rates of various currencies against USD.

Spot Rates as on Closing of 18th April 2019

Spot Rate

Source: www.yahoofinance.com

The above table reflects the rate to be paid by each other currency to purchase U.S. Dollars. These are called spot rates because at that specific instance, or at that spot, this is the exchange rate. It may vary at different timings of the day and on other days as well. Actually, it continuously changes in bps at every second.

Advantages

  • The parties are confirmed with the rate and value of the product for which the transaction is to be made.
  • Spot rate gives the actual movement of markets.
  • There is no speculation involved in the calculation of this rate.
  • There is no effect from market dynamics like volatility, time value, interest rate changes, etc. since buyers and sellers both are sure about the current scenario in the market with no reason for any doubts of future market movement.
  • The study of spot rates for a particular period may help in market price trend analysis for the particular product.

Disadvantages

Limitations

  • It can be beneficial at a particular instance, but it lacks the ability to forecast futuristic rates and movement of the market.
  • It depends upon the demand for that particular product in the market. The higher the demand -the higher is the price. However, if demands vary in the future, price changes, hence, for a buyer who has a bullish view may face losses based on spot rate purchases. This can, however, be hedged by any derivative product which has a future rate of interest as one of its components.
  • It is very dynamic. For liquid products in the market, it changes every second (sometimes even millisecond). Hence, the buyer has to be extremely focused on the purchase and settlement of its desired deal, as small changes in basis pointsBasis PointsBasis points or BPS is the smallest unit of bonds, notes and other financial instruments. BPS determines the slightest change in interest rate, to be precise. One basis point equals 1/100th part of 1%.read more can also have big impacts on some deals depending upon other factors.
  • It is the basic rate. Investors can deal with spot rate contracts that are based on a specific rate and give a conservative income upon a sale. This limitation can be overcome by investing in more dynamic products that deal with futuristic rates.

Important Points to Note About Change in Spot Rate

  • An increase in spot rate reflects the acceptance of the product in markets and vice-versa.
  • The volatile spot rate signifies the instability of the performance of the product in the market. It increases the overall risk of the portfolio and may also affect the performance of other assets in the portfolio.
  • Increases in the spot rate denote a bullish market, and vice-versa. However, it is important to understand the dynamics of such securities prevalent in that instance.
  • Delta, which is the first-order derivative, depends upon changes in the price of the product and is one of the key indicators of market movement for most of the securities.

Conclusion

These rates are one of the most important components denoting the market movement. Even forward rates and other futures/swap contracts work at the reference of spot rates. Movement in spot rate defines a market view for investors. It also defines rates for other derivative products. Investors rely on the spot rate for other parameters defining price components of products. However, in order to make the best from spot rate contracts, sellers of that particular product need to properly analyze all components on which it depends. On the other hand, buyers need to be completely aware of existing market trends, and there should be a mutually agreed rate for the transaction to take place.

Recommended Articles

This has been a guide to what is Spot Rate and its definition. Here we discuss top examples of spot rate along with its advantages & disadvantages and limitations. You may learn more about Derivatives from the following articles –

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