Spot Contracts vs Forward Contracts – What’s the Difference?
The world of currency exchange can be tricky if you’re a business person. It can be a pain to miss out on a spectacular rate because you don’t have the funds you need to right at that moment, and lose hard earned profits. That’s why it’s important to understand what spot contracts and forward contracts are, how to use them, and what the difference between them is.
What Is A Spot Contract?
Currency exchange rates can change at a moment’s notice, so it’s a bummer when exchange brokers are closed and you spot a good rate. It could be gone by morning; what can you do?
A spot contract with Indigo FX is an exchange agreement that lets you reserve a rate for immediate transfer. The way it usually goes is through a verbal agreement. Melanie, a marketing director, is on a tight budget. She sees that the value of the Japanese Yen has decreased, while the value of the British Pound has increased. She can now get more Yen for each Pound she has, and she needs to seal the deal, and fast!
Melanie could call up Indigo FX and request a spot contract for the rate. Indigo FX would then send her a contract note after securing the rate at the requested amount, and the money would transfer to whoever she wants as soon as her funds for payment are cleared. The funds must be received within 2 days to avoid incurring penalties.
What Is A Forward Contract?
Forward contracts are a lot like spot contracts, which is why so many people get them easily confused. You reserve a currency rate in order to secure the best rate you can, but forward contracts allow you to transfer the money on a fixed date. All you need is a 10% deposit paid to Indigo FX for whatever amount you want to transfer.
Melanie has just secured a deal for a marketing campaign with a Japanese beauty product company. The company will receive an agreed upon amount in exchange for providing the products, which Melanie will advertise in the UK. The company gets the exposure and a cut of the profits, and Melanie gets to wow British beauty fans with a new product they’re sure to love.
Since Melanie can’t pay the Japanese company their cut of the profits until she makes some, she wants to lock in an exchange rate that will be beneficial to both her and them. After all, if she can save a few thousand pounds while still paying them the same amount of Japanese Yen, why wouldn’t she?
A forward contract is an extended version of the spot contract. Melanie can pay a 10% deposit on the agreed payment amount now and transfer the entire sum later at the rate she just locked in. The value of the Yen could go up in the next few months, meaning that she would have to pay more Pounds in order to cover the agreed upon amount. Melanie is saving a hefty sum by using a forward contract to get today’s rate reserved for payment later, and protecting her profit margin at the same time.
The Types of Forward Contracts
There are two types of forward contracts: fixed and time option.
Fixed forward contracts can go as far ahead as two years with the condition that all the money is paid for at that time. Since it’s fixed, the date for the exchange and transfer is not negotiable after the contract is signed, and the entire amount is paid for at once.
Time option forward contracts let you utilise the exchange rate bit by bit if you want to. This would be a great option for Melanie, as she could start paying increments of the agreed dividend to the beauty company she made a deal with. That way, they can receive their portion of the profits as they come rather than waiting for the lump sum.
What’s The Difference Between Spot Contracts And Forward Contracts?
The main difference is the time frame. Forward contracts are meant for protecting investments down the line so that unexpected hikes in rates don’t make you end up paying more. Spot contracts are for more immediate use, like when you spot a great sale at your favourite store, but you can’t come back until tomorrow and the sale ends that night.
In essence, forward contracts are for when you have a plan and don’t need the money transferred until much later. Spot contracts are ‘on the spot’, as it were. Both contracts are very useful for businesses who want to make sure they get the best deal possible and shave a few expenses off of their budget. Whether you’re a savvy entrepreneur or a large corporation, spot contracts and forward contracts are a lifesaver.