Spot Contracts – What is a spot contract?

Last updated on 21 Aug 2024

29 Jul 2016 . 3 min read

Deepesh Patel

Deepesh Patel is Editorial Director at Trade Finance Global (TFG) and host of Trade Finance Talks.

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Business Currency

Currency Spot Contracts Forward Contracts FX Options

A ‘buy now, pay now’ deal for immediate delivery, a Spot Contract is the most basic foreign exchange product. Any business or individual can use this product to buy and sell a foreign currency at the current market exchange rate. You can have a currency trader book a trade for you or, using an online system, search for the best available rate and book it yourself.

Once currency pairing, amount and currency exchange rate have been confirmed, a contract is automatically drawn up. This becomes a binding obligation to buy or sell the currency agreed upon.

The date of trade is the day on which the contract is agreed and the settlement date is the day on which funds are physically exchanged and delivered into the account of choice. If the base currency funds are received before the daily cut-off time the settlement date will be the same or next working day, unless requested otherwise.

At Trade Finance Global, our team can not only assess and advise your business on currency solutions for your business, but also suggest the most appropriate financing mechanism, working with currency experts and financiers to help bridge the gap in your supply chain, and help you exchange money in different currencies.

Other Spot Products

Limit Order

A Limit Order can be set when a company does not need to make international payments at a specific time, which gives it the opportunity to wait until a specific exchange rate is reached. Once this has been reached the order will be filled, and occurs 24 hours a day.

Stop Loss

A Stop Loss is an ordering tool that allows firms to purchase currency if the rate hits a level that they do not want to go below. Some organisations prefer to wait and see what the market will do. This allows for a minimum level before the order is filled.

Pricing

The price of the foreign exchange spot market is determined by the supply and demand of the currency in the market. Many factors affect this demand and supply of a certain currency, including interest rates, confidence, current account on balance of payments, economic growth forecasts and relative inflation rates.
For example, if the US Federal Reserve decides to raise interest rates above the rate set by the Bank of England in the UK, it is more attractive for savers to hold dollars which will increase the demand and the value of the US dollar.

Worked Example of a Spot Contract

The below is the convention for sterling (GBP) versus the euro (EUR). Going by the exchange rate equation above, it costs EUR 1.000 to buy 0.800 GBP, and GBP 1.000 (1 ÷ 0.8000) to buy EUR 1.2500.

Pros

Easy to operate. A spot transaction allows you to take advantage of the prevailing exchange rate and deliver the funds to a beneficiary of your choice and time.
Limit orders and stop losses. If time is not an issue and a firm is either aiming for a price or doesn’t want to fall below another, these products are useful as they can be triggered 24 hours a day, also allowing companies to take advantage of short currency spikes.
Lower capital requirement. Unlike forward and option products, where a deposit is normally required, spot transactions require no extra capital.

Cons

High Risk. Using only spot contracts may be a high-risk strategy for a business, because exchange rates can move significantly in a short period of time.
For example: If a UK firm were to place an order of goods (and agree a price in EUR) from Germany for payment in three months’ time, and use the spot market to settle the invoice after the allotted 3-months the company could lose significantly if exchange rates prove to be unfavourable.
This risk can eliminate any profit margins (and even cause losses) that may have been built into the original deal. Therefore a hedging tool such as a forward contract or an option will be preferable.

Case Study

Luxury Clothing Brand

The London Based Company acquired top garments from fashion shows and sales events around the world. It was necessary for the business to execute trades to pay suppliers immediately, therefore a spot contract helped the company purchase clothing in bulk efficiently and immediately.