Spot Rates vs. Forward Rates
The first step in understanding foreign currency exchanges is to have a grasp of the concept of spot rates and forward rates (also known as forward contracts), and the difference between the two.
A spot rate is a currency’s foreign exchange rate at the present moment in time. It is a static price of the currency at this second, this minute, hour, or day. What is important to remember when discussing or working with a spot rate is that it is the rate “right now,” and is the price that has to be paid (or received) for a particular foreign currency if a foreign exchange trade is executed at that moment. In instances that may require the urgent or immediate transfer of foreign currency, to be sent or received, executing a foreign exchange trade using a spot rate is popular because waiting to transfer the foreign currency is not a viable option.
A forward rate is the exchange rate for a foreign currency, at a future point in time, and is obtained through a forward contract. Essentially, a forward contract is an agreement between two parties, who intend to exchange two different currencies at a specified rate, at a future date. This agreement – the forward contract – can result in one party receiving the better end of the bargain, depending on whether the exchange rate between those two currencies moves as predicted, and what the exchange rate is on the date that the forward contract is exercised (the date the currencies are exchanged).
A company is based in the United States, and it has contracted with a company in Japan to purchase goods from it, with payment due in Japanese Yen thirty days from the date of the contract. The company can make the decision to make the payment immediately, executing the foreign currency exchange of U.S. Dollars (USD) to Japanese Yen today at the current spot rate.
The company can also choose to make the payment to the Japanese company at another date, within the thirty-day payment period of the contract terms. However, this means that the company can be exposed to fluctuations in the spot rate, between the two currencies. If the Japanese Yen becomes more expensive to buy in U.S. Dollars, the company may be faced with having to spend more to pay the contract. A forward contract offers the opportunity to lock in a rate in which to exchange the currency at a future point in time. In this way, the company can plan its foreign currency transfer needs, while knowing how much it will cost in its home currency (in this case, U.S. Dollars).