A spot deal is one where foreign exchange is sold or purchased for immediate delivery or latest delivery within two days. the rate at which such deals are conducted is known as the spot rate.
In majority of transactions currency is bought or sold for immediate delivery. “Spot” rate refers to transaction that is required to be completed with two days after the agreement to buy or sell i.e. the time for required for sending instructions to the foreign branch/correspondent to effect payment; usually such time also helps the bank to manage funds. The date of completion of the transactions is known as the value date. If a bank buys a foreign currency direct from a customer the value date would usually be the same day as there would be no need for cable transactions and the rate used will be the spot rate. Spot rates are also known as T.T rates that is the base rate on which the other rates are built up allowing for interest factor to the date of maturity based on the rate of return.
The spot rate is the exchange rate of currency. The spot rate forms the basis for all transactions involving the purchase and sale of one currency against another. In some financial centers, such as in the Far East, it means delivery next day while in London and New York, it indicates that delivery will be made in two clear business, working or banking day time. Hence, it is important to state at the very outset of the inquiry for quotations of a spot deal as to when delivery is required, e.g. spot-today or spot-tomorrow or spot (date). Otherwise, it is the quoting bank’s spot date, which will be applied, if no specific mention of a preferential date is made before the deal is struck.
A forward deal is one where it is agreed to exchange currency at a specified rate but the actual delivery of the currency is for some time in the future, such as one month, three months, six months or twelve months forward.
The forward rate is the price of a currency in terms of another at which it can be bought or sold for delivery at a future date.
A rate which is not spot rate i.e. rate applicable to transactions involving more than two days delivery. A forward rate is a rate of exchange which is fixed now for a deal which will take place at a fixed date or between two dates, in the future. When a forward currency is more valuable than the spot currency, the forward is said to be at a premium whereas when the forward currency is less valuable than the spot, it is said to be at discount, and when the spot and forward currencies are of equal value, the rate is aid to be at “par”.
The forward value dates of standard maturities are calculated on the basis of calendar months in most international financial centers rather than the exact number of days as is followed in some centers. The value dates are fixed with references to the spot dates.
Risks inherent in Spot and Forward transactions.
In spot transactions settlements take place within two working days of the date of deal. The deal requires payment by both the parties simultaneously. However due to time difference, say between Japan on the one hand and USA on the other hand, a deal done at Tokyo will be known only on the second day. Therefore there would be the risk of non-payment by counter party. Therefore it is important to ascertain the market standing and international reputation/credit worthiness of the party with whom the transactions is to take place. For forward transactions the risk is much more as a longer period for completion of transaction would be involved. If at the end of the period say 30 days the counter party fails to deliver/take up the foreign currency in respect of a forward contract, the bank will have to complete the deal thus suffering a loss to the extend the rate has moved adversely.