Tom, Spot and Forward Foreign Exchange Contracts

In order to understand the terms tom rate, spot rate and forward contract we first need to define what these terms are. 

A tom (tomorrow) refers to a foreign exchange transaction when currency delivery is the day after the deal is confirmed. Spot transactions are the most common foreign exchange transactions and refer to foreign exchange bought or sold for delivery two business days after the deal is confirmed. A forward refers to a foreign exchange transaction with a settlement date that is more than 2 business days after the trade date. 

In any foreign exchange contract there are certain variables that need to be discussed.

1)       Two currencies are always involved; the currency that is being bought and the currency being sold.

2)       The amount of currency to be bought or sold.

3)       The rate at which the exchange of currencies will occur.

4)       The date at which the contract matures (forward contract transaction).

A forward contract transaction is the most complicated of the foreign exchange transactions and refers to a financial transaction that will take place in the future. In determining the rate of exchange in a forward contracts there are two important components:

1) The current spot price of the currency pair

2) The interest rates of the two currencies involved or the interest rate differential. 

Forward rates can be calculated from spot rates and interest rates using the formula Spot x (1+domestic interest rate)/(1+foreign interest rate), where the 'Spot' is expressed as a direct rate (i.e. as the number of domestic currency units one unit of the foreign currency can buy).

In other words, if S is the spot rate and F the forward rate, and rf and rd are foreign currency interest rates and domestic currency interest rates respectively, then:

 

For example if the spot USDZAR rate is 8.9 and the interest rates on ZAR and USD are 8.5% and 3.25% annually respectively, then calculated the 1 month USDZAR forward rate.

Thus, in one month, 8.46 ZAR will be equivalent of 1 USD.