Introduction
Forward rates and spot rates are important and related concepts in finance that refer to the future and current prices of financial instruments, such as currencies or bonds.
Forward Rate
The forward rate is the price at which a financial instrument can be bought or sold for delivery at a future date. It reflects the market’s expectation of the future price of the instrument, and is determined by supply and demand in the market, as well as interest rates, credit risk, and other factors. Forward rates are important because they reflect the market’s expectation of future prices and can be used to make predictions about future market conditions. They are used in financial contracts such as forwards, futures and options, as well as in hedging strategies against interest rate and currency risk.
Spot Rate
The spot rate, also known as the cash rate, is the price at which a financial instrument can be bought or sold for immediate delivery. It reflects the current market price of the instrument, and is determined by supply and demand in the market. Spot rates are important because they reflect the current market price of an instrument and can be used to value financial assets. They are widely used in financial transactions, such as currency exchange.
Illustration to Spot Rate
A restaurant that requires fresh products for this week’s operations is an example of a buyer who relies on spot rates. The restaurant must pay the going rate in order for the supplies to be delivered on time because of an urgent business need. As an alternative, a nearby farm may have grown crops that could spoil if not sold within the coming week. The neighborhood farm depends on the spot pricing to sell its produce before it spoils.
Spot rates and forward rates are related to one another, as the forward rate is often derived from the spot rate and the prevailing interest rates. The relationship between spot and forward rates can be used to calculate the forward premium or discount, which reflects the difference between the forward rate and the spot rate for a given time period.
Difference between Forward and Spot rates
The major differences between forward and spot rates are:
Timing
The spot rate is the price at which a financial instrument can be bought or sold for immediate delivery, while the forward rate is the price at which a financial instrument can be bought or sold for delivery at a future date.
Spot rate is the rate at which currencies or instruments are exchanged “on the spot”. Meanwhile forward rates the rates at a predetermined future.
Market Expectation
The spot rate reflects the current market price of the instrument, while the forward rate reflects the market’s expectation of the future price of the instrument.
Interest Rate
Spot rate reflects the present value of an asset, while forward rate reflects the expected future value of an asset based on the prevailing interest rate.
Risk
The spot rate is considered less risky than the forward rate, as the former reflects the current market conditions while the latter reflects the expectations of the market. Future is uncertain, hence, it is riskier.
Usability
Spot rates are widely used in financial transactions such as currency exchange, while forward rates are used in financial contracts such as forwards, futures, and options, and also in hedging strategies against interest rate and currency risk.
Flexibility
Spot rate is fixed at the time of transaction, while forward rate is flexible and can be adjusted according to the market conditions.
Price Difference
The relationship between spot and forward rates can be used to calculate the forward premium or discount, which reflects the difference between the forward rate and the spot rate for a given time period.
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