Spot Rates vs. Forward Rates

If you’re involved in trading, investing, business planning or international finance, you must know the difference between spot rates and forward rates. Understanding the difference plays a big role in decision-making, managing risks and developing investing and pricing strategies. 

Spot rates and forward rates are fundamental concepts at the core of individuals investing in currency markets, businesses trading internationally and financial institutions mitigating risks. This article compares spot rates vs. forward rates to help you better understand the difference in using them in investing, trading, planning and financing.

What Is a Spot Rate?

A spot rate is the price at which assets – securities, commodities, currencies and interest rates – can be bought and sold for immediate payment and delivery. It’s essentially the asset’s market value based on supply and demand at that moment.

In foreign exchange markets, the spot rate is the exchange rate between currency pairs at a certain moment. It shows you the market value of one currency compared to another, the value at which the currency pair can be bought and sold for immediate settlement and delivery.

Since spot rates reflect real-time supply and demand, they can change quickly.

How to Calculate the Spot Rate

The spot rate is simply the price quoted by traders at the time of purchase. However, you can also calculate the spot rate for currencies based on future rate and interest rate differentials to compare bonds with different maturities or to assess future cash flows. 

This is the formula to calculate a spot rate for currency: 

Spot Rate = Forward Rate / (1 + Domestic Interest Rate) x (1 + Foreign Interest Rate). 

Here are the values:

• Forward rate: Exchange rate at a future date
• Domestic interest rate: The interest rate of the local country
• Foreign interest rate: The interest rate of the foreign country

You can use a formula or an online calculator to find the forward rate. With a forward rate between USD (U.S. Dollar) and EUR (Euro) of 1.20, a domestic interest rate of 2% and a foreign interest rate of 1%, the spot rate calculation is: 

Spot Rate = 1.20 / (1 + 0.02) x (1 + 0.01) = 1.20 / 1.02 x 1.01 = 1.1882

What Is a Forward Rate?

A forward rate is a price agreed upon today for a transaction of such assets as securities, currencies and commodities on a specified date in the future. Unlike spot rates – where you take delivery immediately – forward rates are set in advance for later delivery of an asset. This is important because it allows investors, traders and financial managers to reduce uncertainty in volatile markets by locking in a price.

In financial markets, forward rates can offset interest rates, currency exchange rates and commodity prices, lessening the risk of market rates moving against your investments.

How to Calculate the Forward Rate

Spot rates are used when calculating forward rates. When you take delivery of an asset immediately, you and a seller know the spot rate. However, to agree on a price in the future that you both consider fair, you need to calculate the forward rate to account for the time value of money and inflation.

The calculation includes the spot rate and the time interval involved. Here’s the formula: 

Forward Rate = Spot Rate x [ (1 + Domestic Interest Rate x Time) / (1 + Foreign Interest Rate x Time)]

Here’s how to find the forward rate for the EUR/USD currency pair in one year. The spot rate is 1.20. The euro has a domestic interest rate of 0.5% and the U.S. dollar has a foreign interest rate of 1%. 

Forward Rate = 1.20 x [ (1 + 0.005 x 1) / (1 + 0.01 x 1)] = 1.20 x 0.9950 = 1.194. 

So within a year, you must pay $1.194 in U.S. dollars for one euro.

Comparing Spot Rates vs. Forward Rates

If you plan to be involved in international trade or finance, you must understand spot rates vs. forward rates. They are different, despite people often using them interchangeably. Here’s a look at the differences:

Usage

When it comes to spot vs. forward rates, a spot rate is the price you pay now for immediate delivery and a forward rate is a price you agree on now but pay later for later delivery. 

Suppose that you’re a gasoline wholesaler and you must fill your tank farm within two days. You would buy gasoline at the spot rate and take delivery of the fuel in two days. But if you need more fuel in two months and believe the price will rise because of the oncoming driving season, you can enter a forward rate contract to take the fuel at a lower price but take delivery when you need the gasoline.

Timing

Spot rates are subject to the market dynamics of supply and demand, so prices can change rapidly. Spot rates are important to businesses and individuals who must make purchases immediately. While supply and demand play a role in forward rates, businesses and investors are looking longer term and the greater impact comes from market sentiment and the difference in interest rates over time.

Calculation

In the currency market, spot rates are primarily influenced by supply and demand. However, geopolitical events, interest rates, inflation, government debt and economic performance impact spot rates. 

When comparing forward vs. spot rates, interest rate differentials and the period before delivery are key to forward rates. The difference in interest rates and the interval for delivery accounts for differences in inflation between countries and the amount of time your money isn’t earning money.

Know the Difference Between Spot Rates vs. Forward Rates

You must understand spot and forward rates if investing, trading or hedging. The concepts are fundamental to trading currencies, bonds and derivatives. While both concepts involve the pricing of assets or currencies, the timing and use of spot vs. forward rates are different. Knowing the difference can help your decision-making about investments, trades and business.

Frequently Asked Questions