Definition, How They Work, and How to Trade

What Is a Spot Exchange Rate?

A spot exchange rate is the current price at which a person could exchange one currency for another, for delivery on the earliest possible value date. 

Cash delivery for spot currency transactions is usually the standard settlement date of two business days after the transaction date (T+2).

Understanding Spot Exchange Rates

The spot exchange rate is best thought of as how much you would have to pay in one currency to buy another at any moment in time. Spot rates are usually set through the global foreign exchange market (forex) where currency traders, institutions, and countries clear transactions and trades.

The forex market is the largest and most liquid market in the world, with trillions of dollars changing hands daily. The most actively traded currencies are the U.S. dollar, the euro, the British pound, the Japanese yen and the Canadian dollar. The euro is used in many continental European countries including Germany, France, and Italy.

Global forex trading takes place electronically between large, multinational banks, corporations, mutual funds, hedge funds, insurance companies, and government entities.

Transactions are made 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 governments that set the spot exchange rate. For instance, the central government of China has a currency peg policy that sets the yuan and keeps it within a tight trading range against the U.S. dollar.

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 a U.S. dollar vs. the Canadian dollar transaction, 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 various holiday seasons around the world.

On the transaction date, the two parties involved in the transaction agree on the amount of currency A that will be exchanged for currency B. They also agree on the rate of exchange. Finally, the parties also agree on the value of the transaction in both currencies and the settlement date. If the 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. Currency is never meant to be delivered.

Special Considerations

The Spot Market

The foreign exchange spot market can be very volatile. In the short term, rates are often driven by news, speculation, and technical trading. In the long term, rates are generally driven by a combination of national economic fundamentals and interest rate differentials.

Central banks sometimes intervene to smooth the market, either by buying or selling the local currency or adjusting interest rates. Countries with large foreign currency reserves are much better positioned to influence their domestic currency’s spot exchange rate.

How to Execute a Spot Exchange

There are a number of different ways in which traders and investors can execute a spot forex exchange.

• The exchange can be made directly between two parties, eliminating the need for a third party.
• Traders can use electronic brokering systems for automated order matching.
• Traders can also use electronic single- or multi-bank trading systems.
• Trades can be made by voice over the phone with a foreign exchange intermediary.