This article will help you to learn about the difference between spot market and forward market.
Difference between Spot Market and Forward Market
Foreign exchange markets are sometimes classified into spot market and forward market on the basis of the period of transaction carried out. It is explained below:
If the operation is of daily nature, it is called spot market or current market. It handles only spot transactions or current transactions in foreign exchange.
Transactions are affected at prevailing rate of exchange at that point of time and delivery of foreign exchange is affected instantly. The exchange rate that prevails in the spot market for foreign exchange is called Spot Rate. Expressed alternatively, spot rate of exchange refers to the rate at which foreign currency is available on the spot.
For instance, if one US dollar can be purchased for Rs 40 at the point of time in the foreign exchange market, it will be called spot rate of foreign exchange. No doubt, spot rate of foreign exchange is very useful for current transactions but it is also necessary to find what the spot rate is. In addition, it is also significant to find the strength of the domestic currency with respect to all of home country’s trading partners. Note that the measure of average relative strength of a given currency is called Effective Exchange Rate (EER).
A market in which foreign exchange is bought and sold for future delivery is known as Forward Market. It deals with transactions (sale and purchase of foreign exchange) which are contracted today but implemented sometimes in future. Exchange rate that prevails in a forward contract for purchase or sale of foreign exchange is called Forward Rate. Thus, forward rate is the rate at which a future contract for foreign currency is made.
This rate is settled now but actual transaction of foreign exchange takes place in future. The forward rate is quoted at a premium or discount over the spot rate. Forward Market for foreign exchange covers transactions which occur at a future date. Forward exchange rate helps both the parties involved.
A forward contract is entered into for two reasons:
(i) To minimize risk of loss due to adverse change in exchange rate (i.e., hedging)
(ii) To make a profit (i.e., speculation)
Two Exchange rate quotes: In foreign exchange market, there are two exchange rate quotes, namely, buying rate and selling rate. If a person goes to the exchange market to buy foreign currency, say, US dollars, he has to pay higher rate than when he goes to sell dollars. In other words, for a person buying rate is higher than selling rate.