Spot rates and forward rates: what are the differences?
Spot and forward rates are terms used to describe current and future exchange rates that may be used in foreign exchange transactions; whilst they are related, they differ in a number of ways. Here is an explanation.
Because interest rates are not necessarily the same across different currency areas, holding one currency rather than another over a given period may, in some circumstances, work in your favour, and in others, work against you.
Here is a comprehensive overview of everything you need to know to clearly distinguish between the “spot” rate and the “forward” rate, so that you are no longer caught off guard by this nuance of the foreign exchange market.
What is the spot rate?
The spot rate (also known as the “cash rate” or “reference rate”) is the exchange rate quoted on the market for an immediate (within two days) conversion and delivery of your currencies.
NB: This is the rate applied to your foreign exchange transactions with b-sharpe.
What is the forward rate?
The forward rate (also known as the ‘forward exchange rate’) is the exchange rate quoted on the forward market when a market participant agrees to buy or sell a currency at a given exchange rate, but at a future date.
NB: In certain specific cases, such as payments on day J or day J+1, the due date may also be earlier.
Spot Rates vs Forward Rates
If the spot rate and the forward rate are both exchange rates quoted in real time, the former represents a commitment to convert the currency immediately, whilst the latter represents a commitment to convert it at a later date (within three months, for example).
Let us now assume that your Swiss francs (CHF) have a zero yield, but that the US dollars (USD) you wish to purchase have a yield that is 50 basis points higher.
If you are certain that you will need US dollars in three months’ time, you might be tempted to convert your Swiss francs into dollars as soon as possible in order to benefit from a better return over the next three months.
In such situations, you can use certain financial products, such as currency swaps, to take advantage of the interest rate differential between two currency zones and achieve the best possible return on your surplus cash.
Backwardation
When the spot exchange rate is higher than the forward exchange rate, the market is in a state of backwardation. In such a situation, the further out the contract’s maturity date is, the lower the forward exchange rate becomes, falling below the spot rate.
This situation reflects a more favourable interest rate differential for the currency in the numerator (listed first in an exchange rate) compared with the currency in the denominator of the exchange rate (listed second).
Example: If, at any given time, the EUR/GBP pair is in a carry trade situation, then the return offered by the euro (EUR) is likely to be higher than that of the pound sterling (GBP). Consequently, if you hold a large amount of pounds in your accounts and do not need to use them for another three months, you can enter into a three-month swap contract with the euro to take advantage of the better interest rates offered by the single currency, and thus make money.
Contango
When the spot exchange rate is lower than the forward exchange rate, the market is in a contango situation. In such a situation, the further out the contract maturity is, the higher the forward exchange rate is and the greater the difference between it and the spot rate.
This situation reflects a more favourable interest rate differential for the currency in the denominator (listed second in an exchange rate) compared with the currency in the numerator of the exchange rate (listed first).
Example: If, at any given time, the EUR/USD pair is in a carry trade situation, then the return offered by the US dollar (USD) is likely to be higher than that of the euro (EUR). Consequently, if you hold a large amount of euros in your accounts and do not need to use them for another three months, you can enter into a three-month swap contract with the US dollar to take advantage of the better interest rates offered by the greenback, and thus make money.
Which exchange rate should you choose for your foreign exchange transactions?
Whilst sophisticated arbitrage strategies involving spot and forward exchange rates are sometimes used by professional traders and speculators, such practices are of little use to a non-financial company.
In most cases, therefore, a company will prefer to convert its currencies at the spot exchange rate when it receives an international payment or needs to make a payment in foreign currency. Where such payments are not immediate, and where the interest rate differential between the two currencies works in its favour, the company may then use a currency swap to maximise the return on its cash holdings.
Nevertheless, in certain specific situations, and in particular as part of so-called hedging strategies aimed at reducing exposure to foreign exchange risk, the company may use financial products such as forward exchange contracts to hedge its position.
Be wary of exchange rates that appear too good to be true
Just as some foreign exchange providers may offer high and opaque pricing structures, certain financial intermediaries sometimes exploit the difference between spot and forward rates in order to offer exchange rates that appear more attractive than they really are.
Thus, for currency pairs where the forward rate is lower than the spot rate (i.e. where the forward rate is lower than the spot rate), these intermediaries might offer you an exchange rate that appears very competitive at first glance (as it is extremely close to the spot rate), yet is in fact completely prohibitive (as it is significantly higher than the forward rate corresponding to the time horizon over which your currencies will be converted…).
At b-sharpe, all your currency exchange transactions are carried out at the spot exchange rate, and your funds are credited to your accounts on the same day or the next working day! We can also help you optimise your company’s currency management.
The exchange rates shown by our currency converter are therefore not forward rates—which are only available in several weeks or even months’ time—but spot rates: simple, transparent and immediately available.
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