Spot Rate
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May 10, 2019
Spot Rate Definition
“Spot Rate” is the cash rate at which immediate transactions and settlements occur between the buyer and seller parties. It gives the immediate value of the product
being transacted. This rate can be considered for any products prevalent in the market, from consumer products to real estate to capital markets.
Spot Rate Examples
Let’s see some simple to advanced examples to understand it better.
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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
The above example considers that the seller offers Joe a deal. He believes 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 that is a little higher than the spot rate (including the seller’s
premium), also called the , 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 demonstrating the conversion rates of various currencies against the USD.
Spot Rates as on Closing of 18th April 2019
Source: www.yahoofinance.com
The above table reflects the rate paid by each currency to purchase U.S. Dollars. These are spot rates because at that specific instance, or at that spot, this is the
exchange rate. It continuously changes in bps every second. It may vary at different times of the day and on other days as well.
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 are sure about the current scenario in the
market with no reason for any doubts about future market movement.
The study of spot rates for a particular period may help in market price trend analysis for the particular product.
Disadvantages
Spot rate may bring lesser profit to a product buyer inbearish markets. The current spot rate may be higher, so the buyer will pay more today than tomorrow.
Financing also requires other products, which deal with future rates and speculation.
Spot rate brings exchange risks to the 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 a difference in the actual calculation as they fluctuate and may differ at the settlement time.
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 affects its price in the market. However, in such scenarios, almost the entire market gets
affected.
Limitations
It can be beneficial in a particular instance but cannot forecast futuristic rates and market movement.
It depends upon the demand for that particular product in the market. The higher the demand -the higher the price. However, if demands vary in the future,
price changes; hence, a buyer who has a bullish view may face losses based on spot rate purchases. However, this can be hedged by any derivative product with
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 a millisecond). Hence, the buyer has to be extremely focused
on the purchase and settlement of their desired deal, as small changes in can also have big impacts on some deals depending upon other factors.
It is the basic rate. Investors can deal with spot rate contracts based on a specific rate and give a conservative income upon a sale. This limitation can be
overcome by investing in more dynamic products with futuristic rates.
Important Points to Note About Change in Spot Rate
An increase in the spot rate reflects the acceptance of the product in markets and vice-versa.
The volatile spot rate signifies the instability of the product’s performance in the market. It increases the portfolio’s overall risk 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, 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 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 the price components of products. However, to make the best from spot rate contracts, sellers of that particular product must 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.
Recommended Articles
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