International Business

Difference Between Spot and Forward Rates

Spot Rate. If the contract with the customer to buy or sell foreign currency is agreed upon and executed immediately it is known as spot transaction and the rate quoted is the spot rate. For example, purchase of an export bill.

Here the customer tenders the bill for which the bank quotes a rate. If the rate quoted by the bank is acceptable to the customer, the bill is purchased by the bank and the account of the customer is credited with the amount.

Forward Rate.

A forward exchange contract or simply a forward contract is one where a banker and a customer or another bank enter into a contract to buy/ sell a fixed amount of foreign currency at a specified future date at a pre-determined rate of exchange. The rate quoted for the transaction is the forward rate.

For example, Bank of India agrees to buy one month forward US 1 million from Bank of Baroda. That means the delivery of foreign exchange by Bank of Baroda to Bank of India will take place after one month from tile date of contract.

Premium and Discount:

Forward rate may be the same as the spot rate. Then it is said to be ‘at par’ with the spot rate. But it rarely hoppens. More often the forward rate may be costlier or cheaper than the spot rate. The difference between the forward rate and the spot rate is known as the ‘forward margin’.

The forward margin may be either ‘premium’ or ‘discount’. When the foreign currency is costlier under forward rate than under the spot rate, the currency is said to be at a premium. Under direct quotation, more Indian rupees will be needed for a unit of foreign currency under the forward rate than under the spot rate. Therefore, premium is added to the spot rate to arrive at the forward rate.

Under indirect quotation, for a given unit of Indian rupees, the customer would get lesser units of foreign currency than he would get by applying the spot rate. Therefore, premium is deducted from the spot rate to arrive at the forward rate. The addition/deduction of premium is applicable both for purchase and sale transactions. When the foreign currency is cheaper under forward rate than under the spot rate, the currency is said to be at a discount.

Under direct quotation, fewer Indian rupees will be needed for getting a unit of foreign currency under the forward rate than under the spot rate. Therefore, discount is deducted from the spot rate to arrive at the forward rate. Under indirect quotation, for a given unit of Indian rupees, the customer would get more units of foreign currency than he would get under the spot rate. Therefore, discount is added to the spot rate to arrive at the forward rate.

Loading of Forward Margin:

Just as there are two exchange rates, one for purchase and the other for sale, so also there are two rates of forward margin, one applicable for purchase and the other for sale transaction. In case of premium, the lower rate is applicable for purchase transaction and the higher rate is for sale transaction. This applies for both direct and indirect quotations. In case the currency is at discount, the higher discount is applicable for purchase transaction and the lower discount for sale transaction both under direct and indirect quotation.

Note: Premium or discount will be quoted in points (i.e., 0.0001 of the currency concerned). If the two rates of exchange margin for a month are given in ascending order (e.g., 2500/3000), then it is at premium. If the exchange margin is given in the descending order (e.g., 4500/4200), it is at discount.

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