What Is a Spot Contract?
A spot contract is a document that has a purchase, security for quick delivery and payment for the spot date, which is around two days after the trade date.3 min read
2. What Is a Spot Trade?
3. Advantages of Spot Contracts
4. Disadvantages of Spot Contracts
5. Dynamics of Spot Markets
What is a spot contract? A spot contract is a document that has a purchase or sale of a currency, security, or commodity for quick delivery and payment for the spot date, which is around two days after the trade date. The spot price is the current price that is given for settling the spot contract.
Difference Between Spot and Forward Rates
An example is a company who wants to buy orange juice immediately. It will pay the spot price and have it delivered within two days. On the other hand, if this company wants the orange juice to be available in stores in December, it can't make a spot buy for risk of the juice going bad. Since the juice will be needed in months, a forward contract makes more sense.
A forward contract specifies an agreement at the current date for the payment and delivery at a future date. A forward rate quotes a financial agreement that will take place in the future and is an agreed price for a forward contract. Depending on what is traded, the forward rate is determined by the spot rate.
For instance, a Chinese manufacturing company has a large shipment order to the U.S. within one year. The Chinese company does a currency forward for $20 million for Chinese Yuan at a future rate of $0.80 per Yuan. The Chinese company is obligated to deliver $20 million at the rate and date six months from the present, without taking into account the different spot prices.
What Is a Spot Trade?
The price variation between a future or forward contract against a spot contract takes into consideration the time of payment. Foreign exchange spot agreements take two business days and other financial documents settle within the next business day.
The foreign exchange market is the largest and trades over $5 trillion a day. When a currency pairing, amount, and rate are determined, there's a contract created to buy or sell the currency. The trading date is when the contract is agreed upon, and the settlement is when the funds are exchanged and delivered.
The most traded currencies are the Euro v.s. U.S. Dollar and the U.S. Dollar v.s. Japanese Yen. Currencies that are traded and don't include the U.S. Dollar are named cross currencies, which include the Euro v.s. British Pound or Japanese Yen.
Other spot markets include:
- Bonds and options
- Contracts between two finance companies
- An interest rate exchange
- Commodities traded on an exchange, such as the New York Stock Exchange
Commodities are traded for futures and are not delivered. The contract is sold back, and the gain or loss is done in cash.
Advantages of Spot Contracts
- Spot contracts are easy to handle as they allow you to have the current exchange rate while delivering funds to a beneficiary at a future date.
- They limit orders and spot losses since the company can take advantage of waiting for their choice in price, which can be activated 24 hours a day.
- Lower capital is fine when it comes to spot contracts, unlike options for instance.
Disadvantages of Spot Contracts
Spot contracts can be a high-risk strategy for companies since exchange rates are volatile within a short time period. For instance, if a firm in the UK placed on order for Euros from Germany for a payment three months from now and used the spot contract to settle an invoice in three months, this company can lose money if the exchange rates are not favorable. The risk can reduce the profits or even cause losses that were created with the original deal. A forward contract or an option is more favorable.
Dynamics of Spot Markets
- A spot market is a reflection of the true value of the commodity at that point in time.
- Different people like hedgers and speculators create the price process.
- The spot prices change according to supply and demand to offer trading opportunities.
- Since demand changes, this gives players the chance to work with volume in accordance with the market feeling, which is difficult with a fixed contract.
- Spot markets provide arbitrage opportunities given the change in market prices, giving people the opportunity to participate in the market with a profit potential.
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