Finance

Spot Rate and Forward Rate

SPOT RATE:
The spot rate is the price quoted on a commodity, security, or currency for immediate settlement. Also called the “spot price” it is an asset’s current market value at the time of quotation. In essence, this value is based on how much buyers are willing to pay and how much sellers are willing to accept,  which is typically based on a combination of factors like current market value and anticipated future market value. It reflects the supply and demand for an asset in the market. As a result, spot rates change frequently, and can sometimes swing dramatically, especially if there are significant events or relevant headline news.

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The spot rate in currency transactions is affected by the demands of individuals and companies wishing to operate in a foreign currency, as well as by forex traders. It is often called the “benchmark rate,” “straightforward rate” or “outright rate” from a foreign-exchange perspective. In addition to currencies, spot- rated assets include commodities (for example, crude oil, synthetic gasoline, propane, cotton, gold, copper, coffee, wheat, lumber) and bonds. Commodity spot prices are based on supply and demand for these products, while the zero-coupon price for bond spot rates is based. As of bonds, a spot interest rate is a rate of interest on security that makes a single payment at a future point in time. For such terms, the market spot prices are equal to the yield to maturity of zero-coupon bonds.

At any point in time, the price of a risk-free single unit payment at time T is called the discount factor with maturity T, denoted by P(T). The yield to maturity of the payment is called a spot rate, denoted by r(T), that is:
P(T) =1/{1+r(T)}^2

FORWARD RATE:

A forward rate is a rate applicable to a financial transaction that will take place in the future at a specified period of time but is fixed at the present date. In forex, the forward rate defined in an agreement is a contractual obligation which the parties concerned must honor. Forward rates are widely used for currency markets for hedging purposes.

In the context of bonds, forward rates is an interest rate that is determined today for a loan that will be initiated in a future time period. For example, an investor can either buy a one-year Treasury bill or purchase a six-month bill and roll it into another six-month bill when it matures. If both investments yield the same total return, the investor will remain indifferent. The forward rate is the discount rate for a risk-free unit principal payment T* +T years from today valued at time T*, such that the present value equals the forward contract price, F(T*, T)

Therefore,
F (T*, T)= 1/{1+f(T*, T)}^2

EXAMPLE :
The example below shall provide a clear picture as to the concept of spot rate and forward rate and its derivation:
Spot rates are given in the following table for three hypothetical zero-coupon bonds with maturities of one or two, and for three years:
Maturity: 1 2 3
Spot Rates: R(3)=9% R(2)=10% R(3)=11%

Here the spot rates are given as for each year and thus we need to derive the forward rates for :
• 1 year zero coupon bond one year from today
F(1,1) is calculated as follows:
{1+r(2)}^2={1+r(1)}^1 {1+f(1,1)}^1
(1+.10)^2=(1+.09)^1 {1+f(1,1)}^1
f(1,1)= {(1.10)^2/1.09}-1
f(1,1)=11.01%

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DIFFERENCE BETWEEN SPOT AND FORWARD RATE:

• Spot rate is the current price of the commodity at a given period of time the while a forward rate is a contract that involves an agreement of contract terms on the current date with the delivery and payment at a specified future date
• Spot rate is the settlement price of a spot contract while the forward rate is the settlement price of a forward contract
• The spot rate, or spot price, is the price quoted for the immediate settlement of the spot contract while a forward contract can be derived from the spot price.

RELATIONSHIP BETWEEN SPOT AND FORWARD RATE:

When the spot yield curve is downward sloping, the forward yield curve will be below the spot yield curve and vice versa.

 

Author: Bhagyashree Chandak

About the Author: I aspire to become a research analyst and earn and use the best of knowledge.

 

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