Spot price
Encyclopedia
The spot price or spot rate of a commodity
, a security
or a currency
is the price
that is quoted for immediate (spot) settlement
(payment and delivery). Spot settlement is normally one or two business days from trade date. This is in contrast with the forward price
established in a forward contract
or futures contract
, where contract terms (price) are set now, but delivery and payment will occur at a future date. Spot rates are estimated via the bootstrapping method
, which uses prices of the securities currently trading in market, that is, from the cash or coupon curve. The result is the spot curve, which exists for each of the various classes of securities.
(e.g. silver), the spot price reflects market expectations of future price movements. In theory, the difference in spot and forward prices should be equal to the finance charges, plus any earnings due to the holder of the security, according to the cost of carry
model. For example, on a share
the difference in price between the spot and forward is usually accounted for almost entirely by any dividend
s payable in the period minus the interest payable on the purchase price. Any other cost price would yield an arbitrage
opportunity and riskless profit (see rational pricing
for the arbitrage mechanics).
In contrast, a perishable or soft commodity
does not allow this arbitrage – the cost of storage is effectively higher than the expected future price of the commodity. As a result, spot prices will reflect current supply and demand, not future price movements. Spot prices can therefore be quite volatile and move independently from forward prices. According to the unbiased forward hypothesis, the difference between these prices will equal the expected price change of the commodity over the period.
and backwardation
).
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....
, a security
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
or a currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
is the price
Price
-Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...
that is quoted for immediate (spot) settlement
Settlement (finance)
Settlement of securities is a business process whereby securities or interests in securities are delivered, usually against payment of money, to fulfill contractual obligations, such as those arising under securities trades....
(payment and delivery). Spot settlement is normally one or two business days from trade date. This is in contrast with the forward price
Forward price
The forward price is the agreed upon price of an asset in a forward contract. Using the rational pricing assumption, for a forward contract on an underlying asset that is tradeable, we can express the forward price in terms of the spot price and any dividends etc...
established in a forward contract
Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
or futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
, where contract terms (price) are set now, but delivery and payment will occur at a future date. Spot rates are estimated via the bootstrapping method
Bootstrapping (finance)
Bootstrapping is a method for constructing a fixed-income yield curve from the prices of a set of coupon-bearing products by forward substitution....
, which uses prices of the securities currently trading in market, that is, from the cash or coupon curve. The result is the spot curve, which exists for each of the various classes of securities.
Spot prices and future price expectations
Depending on the item being traded, spot prices can indicate market expectations of future price movements in different ways. For a security or non-perishable commodityCommodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....
(e.g. silver), the spot price reflects market expectations of future price movements. In theory, the difference in spot and forward prices should be equal to the finance charges, plus any earnings due to the holder of the security, according to the cost of carry
Cost of carry
The cost of carry is the cost of "carrying" or holding a position. If long, the cost of carry is the cost of interest paid on a margin account. Conversely, if short, the cost of carry is the cost of paying dividends, or rather the opportunity cost; the cost of purchasing a particular security...
model. For example, on a share
Share (finance)
A joint stock company divides its capital into units of equal denomination. Each unit is called a share. These units are offered for sale to raise capital. This is termed as issuing shares. A person who buys share/shares of the company is called a shareholder, and by acquiring share or shares in...
the difference in price between the spot and forward is usually accounted for almost entirely by any dividend
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
s payable in the period minus the interest payable on the purchase price. Any other cost price would yield an arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
opportunity and riskless profit (see rational pricing
Rational pricing
Rational pricing is the assumption in financial economics that asset prices will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away"...
for the arbitrage mechanics).
In contrast, a perishable or soft commodity
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....
does not allow this arbitrage – the cost of storage is effectively higher than the expected future price of the commodity. As a result, spot prices will reflect current supply and demand, not future price movements. Spot prices can therefore be quite volatile and move independently from forward prices. According to the unbiased forward hypothesis, the difference between these prices will equal the expected price change of the commodity over the period.
Examples
A simple example: even if you know tomatoes are cheap in July and will be expensive in January, you can't buy them in July and take delivery in January, since they will spoil before you can take advantage of January's high prices. The July price will reflect tomato supply and demand in July. The forward price for January will reflect the market's expectations of supply and demand in January. July tomatoes are effectively a different commodity from January tomatoes (contrast contangoContango
Contango is the market condition wherein the price of a forward or futures contract is trading above the expected spot price at contract maturity. The resulting futures or forward curve would typically be upward sloping , since contracts for further dates would typically trade at even higher prices...
and backwardation
Backwardation
Normal backwardation, also sometimes called backwardation, is the market condition wherein the price of a forward or futures contract is trading below the expected spot price at contract maturity. The resulting futures or forward curve would typically be downward sloping , since contracts for...
).