How to Use Forward and Spot Rates to Manage Currency Risk

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Contributor, Benzinga
May 9, 2023

If you’re in the process of educating yourself about forex fundamentals before starting to trade currency pairs, then you need to know what spot and forward forex rates are. These forex rates typically differ depending on what settlement date they correspond to.

The settlement or value date of a trade is the future date used for determining the present value of a traded asset that has a fluctuating price or rate of exchange. When the settlement of a foreign exchange trade occurs, the 2 currencies in the currency pair are exchanged between the 2 counterparties in the delivery process.

Read on for more information about spot and forward rates.

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What is a Spot Rate?

Among currency traders, the spot date of a typical foreign exchange deal is the day when it is normally settled. The term arises from the phrase "on the spot" since the trade should be consummated as soon as is practically possible. The spot value date is generally 2 business days from the transaction date.

The notable and lone exception to this 2-day delivery rule is the USD/CAD currency pair that commonly trades in the forex market for delivery in just 1 business day from the transaction date. This is sometimes referred to as trading for “value funds” rather than for spot price to make a clear distinction between the value dates that settlement of the trade is expected to occur on.

The spot value date is also the date when the market quoted exchange rate is not altered based on the interest rate differential between the currencies involved. A spot rate is therefore the exchange rate for a currency pair for delivery on the spot value date.

All currency pairs are quoted and trade in the forex market for delivery on the spot value date. This is also known as “trading for value spot.”

Spot Rate Example

Say that you make a spot transaction in the forex market by purchasing 100,000 EUR versus the USD. Your broker or market maker quotes you an exchange rate of 1.2162, which is the prevailing spot rate for that currency pair.

If you decide to deal at that spot exchange rate, you enter into a spot trade that would ordinarily be scheduled for delivery in 2 business days. Thus, if today is Monday and no bank holidays occur this week, the spot trade will settle on Wednesday.

What is a Forward Rate?

A forward rate is the exchange rate for a currency pair for delivery on some value date other than the spot value date. Since a forward or “forward outright” transaction does not go to delivery on the spot value date, its exchange rate is generally known as its forward rate. A “short date forward” involves settlement before the regular spot value date.

The forward exchange rate needs to be adjusted from the prevailing spot rate based on the interest rate differential between the currencies involved and how far the forward delivery date is from the current spot delivery date. In practice, traders can simply add or subtract the appropriate number of swap points quoted by forward traders from the spot rate to get the forward rate.

Swap points are sometimes also known as forward pips. They are calculated by forward traders to take into account the difference in market interest rates on deposits in the traded currencies in a currency pair.

A trader who has purchased the higher interest rate currency will receive swap points for doing a forward rollover that will add to and hence improve their position’s overall exchange rate. A trader who sold the higher interest rate currency will pay away swap points to rollover their position to a future date. Performing this rollover will subtract from their position’s exchange rate and give them a worse rate.

Forward Rate Example

You can use the following equation to compute the forward rate:

Forward Rate= spot rate+ swap points (converted to exchange rate terms)

In practice, you will get a forward outright rate by asking for a spot rate and swap points from your broker or market maker and then applying the above equation to compute the forward rate. Since swaps are generally quoted in points or pips, you’ll need to convert that to normal exchange rate terms.

If you’re buying a currency pair, then you will trade at the offer side of the spot rate and the swap points. If you are selling the pair, you will trade at the bid side of the spot rate and the swap points.

The 2 interest rates used in calculating the swap points are the prevailing Interbank deposit rates for a deposit concluding on the forward delivery date for each currency in the pair. The London Interbank Offered Rate (LIBOR) for a currency can be used as an estimate. The spot rate is the exchange rate generally quoted in the forex market.

Now consider an example where you wish to compute the forward exchange rate for GBP/USD given a spot rate of 1.3685 and 3-month swap points of +10.3. Note that those swap points convert to 0.00103 in exchange rate terms since 1 pip equals 0.0001 in the GBP/USD exchange rate.

GBP/USD 3 month forward rate = 1.3685 +0.00103 = 1.36953

That means your all-in exchange rate for buying GBP/USD with a delivery date 3 months forward would be 1.36953.

What is a Spot Trade?

A spot trade is simply a forex transaction done for value on the spot delivery date. This means your transaction will settle in 2 business days unless you or your broker takes action to roll it over to prevent delivery.

In practice, a forex trader or their online broker will generally roll their forex trading positions over each evening around 5 p.m. EST to the subsequent value date by doing what is known as a “tom next swap” or rollover transaction. This involves swapping the initial trade that is now value tomorrow for one that is value the next business day, which is the new spot market date.

Performing that tom next rollover transaction makes your trading position again have a spot value date. This means you can avoid going through the delivery process and can readily trade out of the position during the current trading session with the spot price.

Spot Trade Example

Say you purchase 100,000 EUR versus the USD for value spot if you think the EUR/USD exchange rate will rise. Your broker or market maker might quote you an exchange rate of 1.2155/60, so you decide to purchase 100,000 EUR at 1.2160.

If the market exchange rate for EUR/USD rises as expected to 1.2200/05, you can sell out your 100,000 euros at 1.2200. That will give you a profit of €100,000 x (1.2200 - 1.2160) = $400.

Alternatively, if your market view was incorrect and the EUR/USD exchange rate falls to 1.2130/35, you can then close out your trade at 1.2130 for a loss of €100,000 x (1.2160 - 1.2130) = $300.

Where to Find Spot Rates

Several financial market information sources provide spot rate information. These include Bloomberg, Thomson Reuters and Morningstar. Retail forex trader-focused websites like ForexFactory also provide a list of spot rates.

If you plan on trading via an online forex broker, you can also typically display a list of current spot rates using your trading platform. Third-party platforms like MetaTrader 4 and 5 from MetaQuotes provide a watch list of spot rates that updates in real-time. Spot price is an important factor in the currency markets.

Where to Find Forward Rates

Forward rates for a series of standard future delivery dates are typically calculated by traders from spot rates and the swaps to those delivery dates. Forward rates to intermediate delivery dates occurring between standard future delivery dates can then be interpolated in a linear fashion.

Rather than showing forward rates per se, most information sources will instead display spot rates and swaps so that forward outright rates can be calculated by the trader. Several financial market information sources provide swaps that forex traders can use along with spot rates to compute forward rates.

Trade Spot Rates with These Forex Brokers

The forex broker you select to trade through can have a significant impact on your success as a trader. You, therefore, want to select carefully, so make sure they are well regulated and will adequately fit your trading requirements.

You can also open a demo account with an online forex broker funded with virtual money. This lets you try out their services, practice trading using their supported platform and test your trading strategy in a real-time trading environment without the risk of actual financial loss.

Benzinga has made the broker selection process easier for you by creating a comparison table of the best online forex brokers shown below.

  • Forex.com
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    The products and services available to you at FOREX.com will depend on your location and on which of its regulated entities holds your account

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    CFD trading is not available to U.S. users. 76% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you can afford to take the high risk of losing your money.

Immerse Yourself in Currency Exchange Trading

While the mechanics of trading forex might seem rather simple, evolving from a beginner into a successful trader is the much more challenging part of learning to trade forex. This transformation involves developing the right strategy, discipline and mindset required to stay in business over the long haul.

Remember that many forex trading strategies require fast reactions, clerical accuracy and nimble thinking, which may not suit everyone. You will also need to learn to master your emotions, keep your ego in check and humbly admit your trading errors while you remain resilient enough to pick yourself up psychologically and take a risk on another trade.

Frequently Asked Questions

Q

What do you mean by spot rate?

A

The spot rate is the current exchange rate at which an asset or currency pair can be bought or sold for immediate delivery. It is the price of a currency pair in the spot market, which is the market where currencies are bought and sold for immediate delivery. Spot rates are derived from the real-time supply and demand of currencies in the foreign exchange market and are used to value FX derivatives.

Q

Is spot rate the same as yield?

A

Spot rate and yield are two different concepts in the world of finance. Spot rate is the current market price at which a financial instrument can be bought or sold. It reflects the immediate cost of buying or selling a security. Yield, on the other hand, is the income return an investor receives from an investment over a certain period of time.

Q

How do spot rates work?

A

Spot rates are a type of foreign exchange rate that calculates the current market value of one currency in terms of another. Spot rates can be used to make international payments, speculations and hedge against currency risk.

A spot rate is determined by the current supply and demand levels of two currencies in the foreign exchange market. A spot rate quote will typically include two prices: the buying price and

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