Everything about The Spot Price totally explained
The
spot price or
spot rate of a
commodity, a
security or a
currency is the
price that's 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 exist 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 commodity (for example, gold), 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
dividends payable in the period minus the interest payable on the purchase price. Any other price would yield an
arbitrage opportunity and riskless profit (see
rational pricing for the arbitrage mechanics).
In contrast, a
perishable commodity doesn't 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.
A simple example: even if you know tomatoes are cheap in July and will be expensive in January, you can't buy them and take delivery in July, since that'll 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
contango and
backwardation).
Further Information
Get more info on 'Spot Price'.
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