Spot Exchange Rate Better Than Forward Exchange Rate or Not?

What is spot exchange rate?

In foreign exchange markets, currency is exchanged between two parties, wherein one buys one currency and other sells another currency at a rate which is agreed upon for settlement on spot date. The spot exchange rate is the rate at which the currency is exchanged. The spot is two days after the trading day. Thus if T is the trade day, then spot date is two trading days from the trade date, i.e. T + 2.

Most transactions in foreign exchange markets take place for the spot date with data as on April 2019, a daily turnover of USD 2 trillion accounting for 30% of foreign exchange transactions. Though lower than previously surveyed data done three years back – it was 33% in 2016. Trading in FX markets reached a daily volume of USD6.6 trillion in April 2019. Most Foreign Exchange Market transactions are derivatives trading with forex swaps taking the lead. Trading in forwards also picked pace with non-deliverable forwards leading the rise.

What is forward exchange rate?

Forward foreign exchange trades are basically contracts which are executed at a later date. The date could be anything more than T + 2, up to one year. These contracts help in locking in the rate of the foreign exchange. It helps in limiting the losses or gains and as the rate is fixed in advance. Thus a forward foreign exchange is a contract through which one can either buy or sell a fixed amount of foreign currency at a pre-determined price which is settled at a future date or date range. If the future date is fixed then it’s a fixed maturity forward contract but for a range of dates in future it’s called a window forward contract. With high volatility in the currency markets, the Forward Contracts come as a hedging tool for participants who want to cover up the currency risk. For immediate requirement of foreign currency, dealing in the spot market serves better as one can convert the currency at cash (T) and tom (T + 1) discounted rates.

For example, if the today’s spot exchange rate quoted for USDINR is 71.00 and if forward premium for month end is 10 paisa, then -

Date is October 10, 2019

Spot date is October 15, 2019 at spot exchange rate of 71.00

Forward rate for October 31, 2019 is 71.00 + 0.10 = 71.10;

Thus the rate at which US Dollars would be sold on October 31 will be 71.10 irrespective of where the spot exchange rate is on that October 31. Thus locking the exchange rate for October 31 on October 10 itself. Here the spot rate is 71.00 and forward rate is 71.10.

Which is better?

Both spot and forward markets have their own advantages but for a non-trading entity, it’s serves to protect the margins and lock in the rate for future. One may not know what the future holds in place and where the currency may head, but to protect the capital one must hedge open currency positions. Many a times, the law of averaging works during uncertain times. So when the rate is comfortable keeping in mind the set benchmarks, one can hedge partially, say 50% and keep the balance open in anticipation of a better rate. But this should be kept in mind that any open position may lead to losses when the price doesn’t move as expected.

Foreign exchange contracts help in managing risk thereby protecting costs when bought overseas or protecting profit margins when selling abroad. To avoid Currency Fluctuation, one can hedge up to one year. Thus currency hedging can help make forex a profit center than a cost center.

Foreign Exchange contracts

During the uncertain times, as we have understood, one must hedge open positions of anticipated transactions. This helps in maintaining a healthy forex portfolio and ensures the costs are protected at all times. But in order to make the extra buck, often hedgers become traders and get into contracts which are risky and are capable of wiping all the profit margins earned along with the invested capital. Thus dealing in Forward Contract or Future Contract is solely dependent on the investor. As both tend to offer similar service but one is riskier compared to the other. Thus to ensure safety of costing, currency forward contracts are more suitable where as for a trader who is keen on making the quick buck with risk may find currency future more rewarding. But greater rewards warrant greater risks.

Foreign Exchange Advisors

With the advent of technology, global linkage makes it possible to manage currency 24 hours a day through the five days of the week. Thus it might seem a tough task for a layman and that’s why forex expert’s assistance is taken who understand the foreign exchange market movements and monitors the currency market. Keeping a track of the currency movement helps the advisor to take appropriate actions when necessary and if the advisor is on top of his game, substantial profits can be generated through Foreign Exchange Transactions.

This article was first published on www.myforexeye.com

Source Spot Exchange Rate