What it means
A quote such as 1.0850 for the euro against the dollar means one euro costs $1.0850 at that moment. The first currency named is the base and the second is the quote currency, so reading the pair in the right order is the difference between a sensible number and a nonsensical one.
Banks show two prices, a lower bid at which they buy the base currency and a higher ask at which they sell it, and the gap between them is the spread they earn. Spot rates move because of interest rate differences, inflation expectations, trade flows, government policy and sentiment, all interacting continuously.
For a business, the important consequence is that the rate on the day you agree a price and the rate on the day you get paid are almost never the same. A 5% move over a 90 day payment term is entirely ordinary and can wipe out the margin on an export order.
The spot rate is also the anchor for every other currency price. A forward rate, which fixes an exchange rate for a future date, is calculated from the spot rate adjusted for the interest rate difference between the two currencies rather than from any forecast of where the rate will go.
That is why a forward quote is not a prediction and should never be read as one. In the accounts, the spot rate does specific jobs.
Transactions are recorded at the spot rate on the transaction date, monetary balances such as foreign currency receivables and payables are retranslated at the closing spot rate at each reporting date, and the resulting differences go to the profit and loss account as foreign exchange gains or losses. Many finance teams use a monthly average rate for routine transactions to reduce the bookkeeping burden.
Businesses that ignore the spread often lose more to it than they realise. Retail and small business rates can sit 2% to 3% away from the interbank mid rate, which on $2,000,000 of annual conversions is real money, and negotiating a tighter margin over the mid rate is usually the single easiest currency saving available.
In practice
Real-world examples.
Example
A Canadian furniture retailer orders containers from Vietnam priced in dollars and converts at the spot rate on the day each invoice falls due. A 4% move against it between order and payment turns an expected 38% gross margin into 35%, which the buying team only discovers when the management accounts arrive.
Example
A software company invoices a client in Sydney in Australian dollars and receives payment 45 days later. The receivable is recorded at the spot rate on invoice date, retranslated at the closing rate at month end, and the difference is posted as a foreign exchange gain of $3,200.
Example
A traveller changing money at an airport bureau receives a rate around 6% worse than the interbank spot rate quoted online. The bureau is not misquoting, it is simply applying a wide spread and a fixed handling fee to a small transaction.
Formula
Calculation
Cost in home currency = amount in foreign currency x spot rate (home currency per unit of foreign currency)
A United States importer owes a European supplier EUR 500,000, payable on delivery. On the payment date the spot rate is $1.08 per euro, so the cost is 500,000 x $1.08 = $540,000.
Suppose instead that the invoice was agreed three months earlier when the spot rate was $1.08, but the euro strengthened to $1.14 by the payment date. The cost becomes 500,000 x $1.14 = $570,000, which is $570,000 - $540,000 = $30,000 more than budgeted, purely because of the rate. Locking a forward rate of $1.10 at the time of the order would have fixed the cost at 500,000 x $1.10 = $550,000.
The dealing spread adds to the bill. If the bank quotes 1.0800 bid and 1.0850 ask, the importer buys euros at the ask, paying 500,000 x $1.0850 = $542,500 rather than $540,000, so the spread costs $542,500 - $540,000 = $2,500 on this single payment.Case study
Seen in the real world.
The following illustrative and fictional example involves Ravenscourt Instruments, an invented American maker of laboratory equipment. It won an order from a German university worth EUR 800,000, priced when the spot rate was $1.10 per euro, so the sales team booked an expected receipt of 800,000 x $1.10 = $880,000 and built the job's costings around that figure.
Payment terms were 90 days from delivery. By the time the money arrived the euro had weakened to $1.05, and the conversion produced 800,000 x $1.05 = $840,000, which is $880,000 - $840,000 = $40,000 less than planned. Against a budgeted gross margin of $176,000 on the contract, the currency movement alone removed $40,000 / $176,000 = 22.7% of the expected profit.
The fix in this fictional case cost almost nothing. A 90 day forward contract available at the time of the order would have fixed the rate at $1.095, guaranteeing 800,000 x $1.095 = $876,000, only $4,000 below the spot based expectation. Ravenscourt's board adopted a policy of hedging any single currency exposure above $250,000 at the point of order, which removed the guesswork without pretending anyone could forecast the rate.
Watch out
Common mistakes.
- Reading a currency pair backwards, then multiplying when the correct calculation was to divide, which produces an error large enough to distort a whole budget.
- Budgeting a foreign currency contract at the spot rate on the day of quotation and assuming that rate will still apply months later when payment is actually made.
- Comparing a bank's offer to the mid market rate seen online without adding the spread and any fixed transfer fee, so the real cost of conversion is understated.
Questions
People also ask.
What is the difference between the spot rate and the forward rate?
The spot rate is for immediate settlement, while the forward rate fixes today a rate for a future date and is derived from the spot rate adjusted for the interest rate difference between the two currencies.
Which rate should be used in the accounts?
Transactions are translated at the spot rate on the transaction date and outstanding foreign currency balances at the closing rate on the reporting date, with the difference recognised in profit or loss.
Can a small business get a better spot rate?
Usually yes, by asking providers to quote as a margin over the interbank mid rate and by consolidating payments, since a tighter margin on larger transfers costs the provider very little to offer.
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