Spot foreign exchange transactions are simply those which are dealt for delivery on the spot value date. Historically, the term “spot” probably evolved from the phrase “on the spot”. This basically implied that the currencies were being dealt for immediate delivery, which meant two business days for most currency pairs in practice.
Many individuals who wished to trade currencies previously turned to the currency futures market in the past that permitted dealing in smaller amounts. Nevertheless, with the relatively recent advent of online forex trading via retail forex brokers, the highly liquid spot forex market has now become available for even smaller speculators to trade currencies in.
The Spot Market
According to common forex market terminology, a currency deal done for value spot is commonly known as a spot transaction, deal or trade. The spot market is where currencies are bought or sold against other currencies according to the prevailing price for this popular value date.
The market for spot transactions is the largest of the foreign exchange markets, accounting for roughly 30% of dealing volume, and it trades around the clock from approximately 5pm EST Sunday at the Sydney open to 5pm EST on Friday at the New York close.
In a spot trade, the two counterparties to the deal will agree to a rate of exchange or exchange rate and an amount on the transaction date for the exchange of currencies to occur on the spot value date.
When the spot value date arrives, one party then sends the agreed upon amount of one currency to the other party and in turn receives the agreed upon amount of the other currency.
One amount, usually expressed in the base currency, is usually set at the time of the spot transaction, while the second amount, usually the counter currency amount, is computed from the agreed upon exchange rate.
Spot value is generally two business days from the transaction date for any currency pair except for USD/CAD which delivers in just one business day, according to forex market conventions.
Furthermore, although electronic transactions can now permit the almost instantaneous delivery of currencies after a foreign exchange transaction takes place, the forex market convention of usually waiting two business days to deliver the currencies continues to persist.
The Spot Exchange Rate
The spot exchange rate, or the rate at which currencies can be exchanged for value spot, is the most actively traded, market determined price at which a particular currency pair can be exchanged. It often fluctuates considerably over time, and usually presents the greatest risk to a foreign exchange position.
The spot exchange rate also has great significant because it forms the underlying basis for the valuation of virtually all foreign exchange derivatives, including forex forwards outrights, currency futures and currency options.
The spot exchange rate will generally be expressed in how many units of the counter currency are required to purchase one unit of the base currency.
An example of the spot exchange rate for the value of the Euro versus the U.S. Dollar would be 1.2000 for the EUR/USD currency pair, where the Euro is the base currency and the U.S. Dollar is the counter currency. This implies to a forex trader that $1.20 would be required to purchase one Euro for value in two business days.