What is a ‘Spot Exchange Rate’
A spot exchange rate is the price to exchange one currency for another for immediate delivery. The spot rates represent the prices buyers pay in one currency to purchase a second one. Although the spot exchange rate is for delivery on the earliest value date, the standard settlement date for most spot transactions is two business days after the transaction date.
BREAKING DOWN ‘Spot Exchange Rate’
The spot exchange rate is the price paid to sell one currency for another for delivery on the earliest possible value date.
Defining a Spot Exchange Rate
The foreign exchange market is the largest and most liquid market in the world, with over $5 trillion changing hands daily. The most actively traded currencies are the U.S. dollar, the euro — which is used in many continental European countries including Germany, France, and Italy — the British pound, the Japanese yen and the Canadian dollar.
Trading takes place electronically around the world between large, multinational banks. Other active market participants include corporations, mutual funds, hedge funds, insurance companies and government entities. Transactions are for a wide range of purposes, including import and export payments, short- and long-term investments, loans and speculation.
Some currencies, especially in developing economies, are controlled by the government which sets the spot exchange rate.
Spot Exchange Rate Transactions
For most spot foreign exchange transactions, the settlement date is two business days after the transaction date. The most common exception to the rule is the U.S. dollar vs. the Canadian dollar, which settles on the next business day. Weekends and holidays mean that two business days is often far more than two calendar days, especially during the Christmas and Easter holiday season.
On the transaction date, the two parties involved in the transaction agree on the price, which is the number of units of currency A that will be exchanged for currency B. The parties also agree on the value of the transaction in both currencies and the settlement date. If both currencies are to be delivered, the parties also exchange bank information. Speculators often buy and sell multiple times for the same settlement date, in which case the transactions are netted and only the gain or loss is settled.
The foreign exchange spot market can be very volatile. In the short term, rates are often driven by rumor, speculation and technical trading. In the long term, rates are generally driven by a combination of economic growth and interest rate differentials. Central banks sometimes intervene to smooth the market, either by buying or selling the local currency or by adjusting interest rates.
How to Execute a Spot Exchange
There are a number of different ways in which traders can execute a spot exchange, especially with the advent of online trading systems. The exchange can be made directly between two parties, eliminating the need for a third party. Electronic broking systems may also be used, where dealers can make their trades through an automated order matching system. Traders can also use electronic trading systems through a single or multibank dealing system. Finally, trades can be made through a voice broker, or over the phone with a foreign exchange broker.