What is Spot Contract?

What is Spot Contract?

The spot contract is a contract for immediate settlement, that is, for a spot transaction. Precisely for this reason, it is also called a spot contract. The term “spot” translated from English and means immediate, instantaneous.

It is mainly used for agricultural commodities, but also for other types of commodities such as gold, silver and oil, as well as foreign exchange, bonds, electricity and gas.

Understanding the Spot Agreement

First of all, it is necessary to understand what spot in the financial market. The term refers to transactions where the trade date and settlement date are very close together, with a short period of time between them. By settlement date, we mean the day of payment and delivery of the traded asset.

In most cases, we can say that the settlement date of the spot contract is T+2, ie the trade date plus two days.

However, the term depends on the traded asset. Some, such as electricity and gas, cannot be delivered as quickly, but the deadline is still short.

The spot contract, therefore, is the instrument for carrying out a spot transaction; in other words, it is the contract that guarantees immediate settlement. It is essential that the so-called “spot market”, the market for spot transactions, works.

In this type of contract, the settlement rate is called the spot price or spot rate.

Importance of the Spot contract

As already mentioned, the spot contract is very useful, especially for agricultural commodities. For growers, it is a way to quickly raise funds by selling the crop that is already available, or increase their profits by taking advantage of times when the price of their produce is higher than usual.

For companies, the spot contract is also an important tool when they need to obtain raw materials quickly.

For example, an industry that depends on a commodity may need surplus raw material in the face of an unexpected increase in demand, and the spot contract allows receiving this product within a few days of negotiation.

Spot Contract vs. Forward contract

As we have already seen, the spot contract is ideal for a spot transaction. The forward contract, on the other hand, is ideal for that forward transaction where trading takes place now, but the settlement date is in the future.

Choosing between these two contracts is a matter of strategy. To better understand this, let's use a practical example.

Imagine that a company wants to buy soy for its production. Soy is a commodity. Can it be purchased through a spot contract or a forward contract?

If the company needs the soybeans for its production immediately, it makes more sense to use the spot contract, settled in cash.

On the other hand, if the company will only need this soy in six months, it can use the forward contract, guaranteeing the current price, but postponing delivery, to prevent the product from spoiling in the warehouses.

Understanding the logic of the spot contract is very simple with perishable commodities, but don't forget that it can also be applied to items such as gold or currency.

Here's an example with buying dollars:

Suppose a company needs dollars to import urgently needed equipment.

In this case, the spot contract is ideal. On the other hand, if the company intends to import only in the next year and wants to protect against currency fluctuations, it can use a forward contract to guarantee the current price without liquidating the purchase immediately.

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