Introduction
In the dynamic world of financial markets, participants have diverse objectives. Some seek instant delivery of securities, while others opt for future contracts.
The spot market, also known as the cash or liquid market, facilitates immediate settlement. However, exchanges require time for transaction processing. In India, stock exchange settlement occurs on T+2 days, considered spot transactions.
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Here, sellers surrender holdings and buyers pay the current market value. Conversely, the futures market involves price determination in the present, with money and securities transferred on a future date.
What is a Spot Rate?
The spot rate, also known as the “spot price,” represents the immediate settlement price for various assets, like interest rates, commodities, securities, or currencies. It reflects the current market value of an asset available for instant delivery.
The spot price is determined by the willingness of buyers to pay and sellers to accept, influenced by factors like current and expected future market values. While spot prices vary by time and location, they tend to be relatively consistent globally, considering exchange rates.
How does a Spot Rate work?
Let’s delve into how spot rates work with an example.
Imagine a wholesaler in September who needs fruits delivered within two business days. They pay the spot price to their seller for immediate delivery. However, the wholesaler anticipates higher prices in late January due to increased demand and limited supply. Since the fruits are not needed until then, a spot purchase carries the risk of spoilage.
In this case, a forward contract is more suitable. This illustrates how spot prices and forward contracts are utilized in market transactions. While physical commodities involve traditional or future contracts referencing spot prices, traders often use option contracts to mitigate delivery-related risks.
What is the difference between the Spot Rate and the Formal Rate?
Spot settlement, which finalises a spot contract, typically takes place one or two business days from the trade date. This is known as the spot date. Regardless of market fluctuations, the transaction will be completed at the agreed-upon spot rate. The spot rate plays a crucial role in determining the forward rate, which represents the price of a future financial transaction.
The expected future value of a commodity, security, or currency depends on its current value, risk-free rate, and time until contract maturity. Traders can estimate an unknown spot rate by considering the future price, risk-free rate, and time to maturity.
Conclusion
The spot rate is the quoted price of a security, subject to market fluctuations. It serves as a basis for determining the forward price of the security.
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