Nov 22

Spot, Forward and Future Markets

Future Markets bonds, futures, shares, stock market Comments Off

Companies needing to buy or sell assets immediately deal through spot markets. Spot market prices are determined by supply and demand at the time the trade is made and can be quite volatile and are generally difficult to forecast well. These transactions usually result in the exchange of an asset for a cash consideration. Settlement may take place immediately, as is usually the case in street markets, but in financial markets there is usually a short delay between the trade being agreed and its actual settlement of one or two working days.
Companies dealing through spot markets are exposed to a number of risks, in particular concerning price and the certainty of sale or purchase. The example of the farmer and the food processing company is almost always used to illustrate the nature of risks arising from relying on spot markets. At the time the farmer sows his seed he has no idea what spot prices will be at harvest time. Good weather conditions may result in a glut pushing down spot prices. The food processing company is exposed to the risk that crops fail and spot prices rise sharply. Commodity futures markets developed to allow both parties to hedge their risks without having to deal directly with the other.
Most texts stop at this stage and fail to point out that both parties are still exposed to other forms of risk. The farmer is committed to deliver at the agreed price even if his crop fails and prices rise sharply. The food company is committed to pay and take delivery even if it subsequently finds that it has no need for the raw materials.