Definition: The spot exchange rate is the amount one currency will trade for another today. In other words, it’s the price a person would have to pay in one currency to buy another currency today. You could also think of it as today’s rate that one currency can be traded with another.
What Does Spot Exchange Rate Mean?
It’s the way foreign exchange rates are expressed as the foreign currency per unit of the domestic currency or vice versa, enabling investors to equate the price of a good or a service in a common currency.
Usually, spot transactions in the interbank market involve large transactions, whose bank settlement takes place on the second following business day. Furthermore, spot transactions account for 43% of the total foreign exchange transactions.
Thus, the foreign exchange spot market is prone to fluctuations and high volatility, especially in the short-term. As speculators often create noise around a currency, they affect the exchange rate. In cases that the foreign exchange spot market fluctuates sharply, the government sometimes intervenes to adjust interest rates or to make transactions in the domestic currency, so their country isn’t put in a trading disadvantage with other countries. Sometimes this is referred to as currency manipulation.
Let’s look at an example.
A U.S. multinational imports textile from Bangladesh and Pakistan. The company is required to pay 5 billion Bangladeshi Taka to the company from Bangladesh and 11 billion Pakistani Rupee to the company from Pakistan, today. Jonathan, who works in the accounting department, uses today’s exchange rate to convert the Bangladeshi Taka and the Pakistani Rupee in US dollars.
1 Bangladeshi Taka = 0.013 US Dollar, therefore 5 billion Bangladeshi Taka = 5,000,000 x 0.013 = $65,000
1 Pakistani Rupee = 0.0095 US Dollar, therefore 11 billion Pakistani Rupee = 11,000,000 x 0.0095 = $104,500
Therefore, the U.S. multinational has to sell $65,000 to pay its supplier from Bangladesh and $104,500 to pay its supplier from Pakistan.