Spot Contracts

What is a spot contract?

A spot contract is the most basic of all foreign exchange products available. It involves the purchasing or selling of currency for immediate settlement on the spot date. The trade is done at the current rate at the time you wish to make it and is often based on the urgency of your requirements. This means that you are dependent on the currency market exchange rate at that time and on the day the spot transaction needs to be made.

When would you use a spot contract?

Spot contracts can be thought of as a ‘buy now, pay now’ arrangement and are particularly useful if you need to make an immediate or urgent international payment.

Advantages and disadvantages of spot contracts

As with any financial product, there are pros and cons to spot contracts and whether you decide to go ahead with this particular product should depend on your exact requirements.

• As mentioned above, if you need to make an international payment in an extremely short space of time, then spot contracts are particularly useful, as you can deliver the funds to a beneficiary in a timely fashion.
• However, using spot contracts without leveraging your exposure with other financial products can be a high-risk strategy. Given how volatile the currency markets can be from one day to the next, it is important to think about the bigger picture.

Let’s imagine, for example, that you decide to place an order for goods from the US that requires payment in three months’ time:

If you use a spot contract to settle that particular invoice, then you are putting yourself at the mercy of the currency gods (who do not always smile kindly). The rate at which you settle the spot contract could significantly change in the three months, meaning that the price you paid for the goods is substantially higher than it would otherwise have been.

Of course, the markets might move in your favour in three months’ time but, as there is no way of knowing, it is worth considering alternative financial products if you do not need to make an immediate payment.

What is the difference between a spot contract and a forward contract?

If you have time to spare and want to avoid a scenario where the markets move unfavourably, you could take advantage of a forward contract instead. Forward contracts enable you to reserve a forward price for buying or selling currencies on a specific date in the future. They are a ‘buy now, pay later’ agreement, meaning you avoid any currency fluctuations and know exactly how much you’ll be paying in the future.

A spot contract allows you to trade immediately at the current rate. However, a forward contract can be used to lock in a rate for payments in the future.

The ‘expected future spot rate’ is the currency exchange rate that is expected to take effect at a particular point in the future – this is based on estimations. A forward rate is the current exchange rate that has been locked in to take effect on a future date.