Forward Rate Vs. Spot Rate: What’s the Difference?

Forward Rate Vs. Spot Rate: An Overview

The forward rate and spot rate are different prices, or quotes, for different contracts. A spot rate is a contracted price for a transaction that is taking place immediately (it is the price on the spot). A forward rate, on the other hand, is the settlement price of a transaction that will not take place until a predetermined date in the future; it is a forward-looking price. Forward rates typically are calculated based on the spot rate.

Spot Rate

A spot rate, or spot price, represents a contracted price for the purchase or sale of a commodity, security, or currency for immediate delivery and payment on the spot date, which is normally one or two business days after the trade date. The spot rate is the current price of the asset quoted for the immediate settlement of the spot contract. For example, if a wholesale company wants immediate delivery of orange juice in August, it will pay the spot price to the seller and have orange juice delivered within two days. However, if the company needs orange juice to be available at its stores in late December, but believes the commodity will be more expensive during this winter period due to a higher demand than supply, it cannot make a spot purchase for this commodity since the risk of spoilage is high. Since the commodity wouldn’t be needed until December, a forward contract would a better fit for the investment.

Spot prices are most frequently referenced in relation to the price of commodity futures contracts, such as contracts for oil, wheat, or gold. This is because stocks always trade at spot.

Forward Rate

Unlike a spot contract, a forward contract, or futures contract, involves an agreement of contract terms on the current date with the delivery and payment at a specified future date. Contrary to a spot rate, a forward rate is used to quote a financial transaction that takes place on a future date and is the settlement price of a forward contract. However, depending on the security being traded, the forward rate can be calculated using the spot rate. Forward rates are calculated from the spot rate and are adjusted for the cost of carry to determine the future interest rate that equates the total return of a longer-term investment with a strategy of rolling over a shorter-term investment.

For example, if a Chinese electronics manufacturer has a large order to be shipped to America in one year, it might engage in a currency forward and sell $20 million in exchange for Chinese yuan at a forward rate of $0.80 per yuan. Therefore, the Chinese electronics manufacturer is obligated to deliver $20 million at the specified rate on the specified date, six months from the current date, regardless of fluctuating currency rates.

Key Takeaways

  • A spot rate is a contracted price for a transaction that will be completed immediately.
  • A forward rate is a contracted price for a transaction that will be completed at an agreed upon date in the future.
  • The spot rate typically is used as the starting point for negotiating the forward rate.

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Written by sortiwa