Spot rates and forward rates: what are the differences?

Because interest rates are not necessarily the same from one currency zone to another, holding one currency rather than another over a given period can, in certain circumstances, work in your favour, and in others, work against you.

Here is a complete overview of everything you need to know to fully understand the difference between the “spot” rate and the “forward” rate, so that this subtlety of the foreign exchange market never catches you off guard again.

What is the spot rate?

The spot rate (also known as the “cash rate” or “reference rate”) is the exchange rate offered on the market for an immediate conversion and delivery (within 2 days) 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 offered on the forward market when a party agrees to buy or sell a currency at a given exchange rate, but on a later date.

NB: In certain special cases, for example when payments are made on T or T+1, the settlement date may also be earlier.

Spot Rate vs Forward Rate

While the spot rate and the forward rate both correspond to live-quoted exchange rates, the former is a commitment to convert currencies immediately, whereas the latter is a commitment to convert them at a later date (in 3 months’ time, for example).

Now let’s assume that your Swiss francs (CHF) have a zero return, but the US dollars (USD) you wish to acquire have a return that is 50 basis points higher.

If you know for certain that you will need US dollars in 3 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 3 months.
In such situations, you can make use of certain financial products such as currency swaps to take advantage of the interest rate differential between two currency zones and obtain the best possible return on your cash surpluses.

Backwardation

When the spot exchange rate is higher than the forward exchange rate, the market is said to be in backwardation. In such a situation, the further away the contract’s maturity date, the lower the forward exchange rate is, and the further below the spot rate it falls.

This situation reflects an interest rate differential that is more favourable for the currency in the numerator (the one listed first in an exchange rate) compared to the currency in the denominator of the exchange rate (the one listed second).

Example: If, at a given moment, the EUR/GBP pair is in backwardation, then the return offered by the euro (EUR) is likely to be higher than that of the pound sterling (GBP). As a result, if you hold large amounts of pounds in your accounts that you will only need in 3 months’ time, you can use a 3-month SWAP contract with the euro to benefit from the better interest rates offered by the single currency, and thereby make money.

Contango

When the spot exchange rate is lower than the forward exchange rate, the market is said to be in contango. In such a situation, the further away the contract’s maturity date, the higher the forward exchange rate is, and the further above the spot rate it rises.

This situation reflects an interest rate differential that is more favourable for the currency in the denominator (the one listed second in an exchange rate) compared to the currency in the denominator of the exchange rate (the one listed first).

Example: If, at a given moment, the EUR/USD pair is in contango, then the return offered by the US dollar (USD) is likely to be higher than that of the euro (EUR). As a result, if you hold large amounts of euros in your accounts that you will only need in 3 months’ time, you can use a 3-month SWAP contract with the US dollar to benefit from the better interest rates offered by the greenback, and thereby make money.

Which exchange rate should you choose for your foreign exchange transactions?

While sophisticated arbitrage strategies between spot and forward exchange rates are sometimes used by professional traders and speculators, such practices make little sense for a non-financial company.

In most cases, a company will therefore prefer to convert its currencies at the spot exchange rate when it receives an international payment or has to make a payment in foreign currency. When these payments are not immediate, and when the interest differential between the two currencies is in its favour, the company can then use a currency swap to maximise the return on its cash holdings.

However, in certain specific situations, particularly as part of so-called hedging strategies aimed at reducing exposure to exchange rate risk, a company may then turn to financial products such as forward foreign exchange contracts to hedge itself.

Be wary of exchange rates that appear too good to be true

Just as some foreign exchange providers may offer high, opaque pricing structures, some financial intermediaries sometimes play on the difference between the spot rate and the forward rate to offer exchange rates that appear more attractive than they really are.

As a result, for currency pairs in backwardation (when the forward exchange rate is lower than the spot exchange rate), these intermediaries could offer you an exchange rate that at first glance seems highly competitive (because it is extremely close to the spot exchange rate), yet is in fact entirely prohibitive (because it is far higher than the forward exchange rate corresponding to the actual time horizon over which your currencies will be converted…).

At b-sharpe, all your foreign exchange transactions are carried out at the spot exchange rate, and your funds arrive in your accounts the same day or the next business day! We can also support you in optimising the management of your currencies for your business.

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.