What is Spot Market?
Spot Market, also known as “physical market” or “cash market” is a financial market where financial securities like stocks, currencies, commodities are bought and sold for immediate delivery. Most of the spot market trades are settled or delivered on two business days after the trade date (T+2) but many of the counterparties opt for settlement ‘right now’. The settlement price or the rate is called the spot price. An investor who wishes to own stocks of a company immediately will buy the stock in the spot market which will allow him/her to own the stocks with immediate effect.
WTI or Brent Crude oil is traded at the spot price but the delivery is done only after a month or so. Since it is a commodity, the delivery usually takes time. Whereas in the case of stocks, it is delivered immediately once the payment is made and the ownership gets transferred as well.
Types of Spot Market
The following are components of the spot market.
The cash market can be either exchange-traded or traded over the counter. It depends on where the trade takes place. Exchange brings together buyers and sellers in one place and facilitates trading whereas an over the counter trade happens with a closed group of participants which does not have a central location.
#1 – Exchange-Traded
- Exchange provides the spot rate at which the securities are traded.
- Buyers and sellers of financial securities are brought together at a central place in exchange.
- Trades done via an exchange carry limited risk when compared to trades executed over the counter due to the less risk of a counterparty defaulting.
#2 – Over Counter
- Over the counter, trades are carried out between a limited group of counterparties.
- Over the counter, trades weigh more risk than trades.
- The trades executed over the counter are usually traded at the exchange rate.
Examples of Spot Market
The following are some examples of the spot market.
John owns a fabric business in New York and is looking for suppliers dealing with good quality fabrics at a competitive rate. He looks upon the internet and finds a Chinese supplier giving almost 40% discount on bulk orders of over $ 10,000. The payment needs to be made in CNY and John might save big if the current market rate for USDCNY is high.
He checks the current USDCNY rate which is 7.03 which higher than usual value. But looking at the discount the supplier is giving John decides to execute a foreign exchange to convert the CNY equivalent of $10,000.
- USDCNY = 7.03
- Purchase amount = $ 10,000
- CNY amount = $ 10,000 * 7.03
- CNY Amount= 70,300
The foreign exchange spot transaction settles or is delivered after 2 days (T+2) and John is able to make the payment which allows him 40% savings on his purchase.
Steve is looking to invest $ 5,000 in the stock market. He is unsure of how he should start. He starts a Demat account with one of his trusted banks. He checks into the various stocks being traded over the market. Due to fear of losing his money, he is interested to put his money only into the blue-chip stocks. He buys 100 shares of Apple at $ 200.47. He makes the payment for it and has 10 shares of Apple in his account; the spot market also allows immediate settlement. This allows Steve to get ownership of Apple shares on the same day. Steve also looks for other penny stocks which he thinks might turn up into a good performer. He invests $ 2,000 in two different penny stocks.
Now, Steve has $ 1,000 ready to be invested. He decides to invest in currencies. He looks at the market trends and invests in the Chinese yuan expecting it to go up due to the news surrounding China’s economic growth. He assumes the Chinese Yuan to perform well in the long term and hence invests the remaining $ 1,000 in currency.
The trade settles in 2 days and the account will be delivered with Chinese Yuan.
Important Points about Spot Market
- Unlike a spot trade, a futures contract gives the investor the obligation to buy or sell the financial security at a pre-agreed price and a future date.
- Money changes hands at a later date, that futures prices demonstrate where part of the market expects the price of an asset to go while the spot price is the price at that moment.
- A futures transaction in which a commodity is expected to be delivered or settled in less than a month is also part of the cash market. It may have been sold at the spot price but the ownership is transferred only at a future date which is not immediate.
- The physical market is regulated by local regulations.
- The price quoted for a purchase or sale on a spot market is called as the Spot Price.
Advantages of Spot Market
Some of the advantages are as follows.
- The spot market is more flexible than a futures market since the spot market can be traded on lower volumes (1,000 units) whereas a futures market requires higher volumes (usually 100,000 units, the exception in very few instruments).
- A spot market is quick and the delivery is usually with two days.
- A spot market is straight forward unlike a futures market.
- The physical market facilitates immediate trading with a transfer of funds and ownership in a short span of time.
- It is most favored by traders due to its flexibility and ease of trading rather than the futures market which can be complex and time-consuming.
- When security is bought or sold and then settled or delivered immediately it refers to a physical market transaction.
- Contracts bought or sold in the spot market are immediately effective.
- A physical market is different from a futures market since the money is exchanged immediately.
- Spot market allows the immediate transfer of ownership of securities.
This has been a guide to what is spot market and it’s a meaning. Here we discuss examples of the spot market along with its components and advantages. You can learn more about financing from the following articles –