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.
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.
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We can also say that this rate is the real market rate which shows actual market movement.
In the above example, considers that the seller offers Joe with a deal. His view is that the market will be bullish in future and gold rates will rise. He suggests Joe book the bullion today at $455.00 and collect the same after 1 month. Rates after 1 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 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.
It can be measured for Currency exchanges as well. Below is a table which demonstrates conversion rates of various currencies against USD.
Spot Rates as on Closing of 18th April 2019
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.
- 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 buyer and seller both are sure about the current scenario in the market with no reason of any doubts of future market movement.
- Study of spot rates for a particular period may help in market price trend analysis for the particular product.
- Spot rate may prove to bring lesser profit to a buyer of the product in case of bearish markets. Current spot rate may be higher due to which the buyer pays more today than tomorrow.
- Financing requires other products as well which deal with future rates and speculation.
- Spot rate brings exchange risks to individual, corporate and other finances, since the current rate may not be equivalent to the rate at the time of settlement.
- Floating rates may create the difference in the actual calculation as they fluctuate and may be different at the time of settlement.
- It also depends upon market situations which include political scenarios, war conditions, an act of God situations and other environmental activities. Although this may not be directly related to product performance, it actually affects its price in the market. However, in such scenarios, almost the entire market gets affected.
- 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, higher the demand -higher is the price. However, if demands vary in 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 purchase and settlement of its desired deal, as small changes in basis points can also have big impacts for some deals depending upon other factors.
- It is the basic rate. Investors can deal in spot rate contracts which 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 which deal with futuristic rates.
Important Points to Note About Change in Spot Rate
- Increase in spot rate reflects the acceptance of the product in markets and vice-versa.
- Volatile spot rate signifies instability of 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.
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.
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 –