Question

Discuss the difference between the spot and forward markets. Explain why are the rates different. When are they quoted? What is the function of interest rates in the quotes?

Answer 1

Spot markets refer to the markets of actual physical underlying assets for physical delivery. These may be stocks, commodities, interest rates etc.

Forward markets refer to the trading of the same underlying assets as in spot markets but at a future date, For example, if you buy gold (in form of gold coins etc.) & take the delivery today (or within 1-2 days after paying today) you would be said to be trading in the spot market.

If instead, you enter in a contract with a seller to buy 100 grams worth of gold coins six months from now at a price decided today between you and the seller., you would be said to be trading in the forward market.

The rates are different because spot rates represent the actual price of the underlying asset today whereas the forward rates represent the expected price of the underlying asset on the date when the transaction & delivery has been decided to take place.

Both the spot rate & forward rates are quoted at the time when the transaction is to be initiated or the contract is to be entered i.e. both are quoted at present terms.

The function of interest rates in quotes:

1. Spot rates: Interest rates do not affect the quotes in spot market quotes as they represent the price/rate as of today.

2. Forward markets: Forward price quotes represent the expected future value of the spot rates of today (adjusted for expected income/carrying costs associated with the physical assets)

Forward price= Future value of spot price compounded at the interest rate - FV of incomes from the asset + Carrying costs associated with the asset.

For an asset that has no income or cost associated and the risk-free interest rate is 'r' compounded continuously, we can write the t-period Forward price F in terms of spot price S as:

F= S * e^{(r * t)}

Thus interest rates play a very important function in forward rate quotes.