What is a cash market? Definiton and meaning
A cash market, also known as a spot market (transaction is done ‘on the spot’) or physical market, is a public financial market where commodities or financial instruments are bought and sold for immediate delivery.
Cash markets contrast with futures markets, where delivery is for a later date.
In a cash market, settlement occurs within up to two working days, i.e. cash must be paid and the product delivered and received within two working days of the trade date.
In the spot foreign exchange market, for example, which is among the largest cash markets, there is a two-day delivery requirement, originally because of the time it would take to move the money from one bank to another.
The majority of speculative retail forex trading is carried out as spot transactions on an online trading platform.
Cash market trades may be carried out at an exchange, an organized market, or over-the-counter (OTC). In the OTC market, transactions are based on contracts made between two parties that are not subject to the rules of an exchange.
For farmers, there are pros and cons regarding waiting for the right price or locking into a forward contract.
The price of a specific commodity in the cash market is typically less that its futures market price. The carrying costs, such as insurance and storage involved in holding the commodity until it is delivered, make it more expensive in a futures market.
Importance of knowing cash market and futures market
Investors need to know the difference between cash and futures markets, as well as the difference between spot and futures prices.
The time spread (the difference) indicates the market’s expectations about futures prices.
While cash markets are influenced mainly by supply and demand, futures markets are driven by expectations about later prices, as well as weather forecasts (for perishable commodities), storage and insurance costs.
A commodity is a good produced in bulk that can be bought and sold, such as coffee, meat, grain, metals and oil.
Cash market and forward contracts in farming
Farmers can store their harvest and sell when the price is right. They also have the choice of a forward contract where they agree to deliver a certain amount of a specific commodity at a given time in the future.
As nobody can accurately foretell whether a product will go up or down in price, a forward contract locks in a price that is higher than the current cash price.
Some farmers prefer to have a guaranteed price for their product, and use forward contracts. Others do a bit of both, store some and tie up the rest in a forward contract.
Both have advantages and disadvantages. By storing your product and waiting, you might get a really good price. However, you risk facing a declining price trend and losing out.
By locking into a forward contract, you have the peace of mind of a guaranteed price, but could also lose out if later on the price shoots up.
According to the FT Lexicon, cash markets:
“(Is a) term used in derivatives trade to describe the markets of underlying securities or commodities in which transactions are completed immediately rather than at some agreed time in the future.
Video – Cash markets and forward contracting
This Iowa Public Television video shows how farmers can store their harvest and sell at the right time in a cash market, or take advantage of forward contracting (futures market).