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Description: This forex course basics section covers the nature of spot foreign exchange transactions and the spot market.
The definition for a spot transaction in the foreign exchange market is transactions that are performed between two counterparties for mutual delivery of currencies on the spot value date.
The term is believed to originate from the colloquial phrase “on the spot”, implying immediate delivery on the trade.
Spot Transactions in the Spot Market
Spot transactions, deals or trades refer to the type of currency or foreign exchange transactions which settle for delivery on the spot value date. This is usually two business days after the transaction is executed.
The spot market is the network where currencies trade against other currencies for delivery on the spot value date. The spot rate at which the exchange takes place is determined according to the prevailing market conditions, such as the levels of supply and demand for each currency in the pair traded.
The spot market makes up the largest part of the foreign exchange market by volume of trades, with over 30% of all forex transactions taking place in the spot market. In addition, the spot market trades 24 hours a day, five days a week, being open for trading from 5:00 PM EST on Sunday until 5:00 PM EST on Friday.
Spot Trades Explained
A spot trade consists of two counterparties agreeing to deal at a certain rate of exchange for a particular amount of one currency to be delivered against a particular amount of another currency on the spot value date.
On the spot value date, each party to the trade sends the agreed upon amount of the currency which they had contracted to sell to the other party, and prepare to receive the specified amount of the currency they had contracted to buy in the foreign exchange transaction.
One amount, which will generally be expressed in terms of the currency pair’s base currency, is set before the spot transaction actually takes place and forms part of the quotation request.
The second currency amount, which is usually expressed in terms of the counter currency, will then be calculated from the exchange rate agreed upon after the trade is quoted and dealt.
According to currency market conventions, spot value in the forex market is two business days from the execution of the transaction in all currency pairs, with the sole exception of the U.S. Dollar against the Canadian Dollar for which spot value is one business day.
Despite the possibility of immediate delivery of currencies with current electronic systems, the two business day delivery convention in the forex market continues to be the norm.
The Spot Exchange Rate
The rate at which currencies can be exchanged for value spot is referred to as the spot exchange rate.
The spot exchange rate is the most actively traded price determined by the market at which a currency pair can trade. The spot rate tends to fluctuate over time and presents the largest element of trading risk involved in most foreign exchange deals.
The spot exchange rate is typically expressed as the number of units of the counter currency which it takes to purchase one unit of the base currency.
For example, if the exchange rate of the E.U.’s Euro against the U.S. Dollar is 1.2000, this would mean that it takes $1.2000 to purchase one Euro deliverable in two business days.
In addition to its significance outlined above, the spot rate is important in the valuation of many foreign exchange derivative products. These include forward outrights, currency options and currency futures contracts.