Spot Market

Spot Market refers to 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 two business days after the trade date (T+2), but many counterparties opt for immediate settlement.

Also known as physical market or cash market, these markets ensure the securities or assets are sold and the cash in exchange is instantly received. The settlement price or the rate is called the spot price. For example, an investor who wishes to own stocks of a company immediately will buy the stock, which will allow them to own the stocks with immediate effect.

Spot market, as the name implies, is the market where dealings take place on the spot. The buyers are sellers are ready to buy and sell the assets or securities immediately and get the products delivered then and there without delay. Normally, the time taken to trade a security is two business days after the trading day, i.e., T+2. However, in this market arrangement, the delivery is instant.

Spot market arrangement is evident for all kinds of assets and securities, including stocks, bonds, commodities, currencies. They can be traded at the exchange, which brings together the dealers and traders to trade different financial instruments. The exchanges that allow spot price dealings include New York Stock Exchange (NYSE), Chicago Mercantile Exchange (CME), etc.

On the contrary, the traders and dealers can connect directly and opt for over-the-counter (OTC) transaction. Not many exchanges allow instant trading, which is the main criteria of a spot market transaction. Hence, OTC is preferred.

A spot market dealing calls for immediate transfer of ownership of securities. There are local regulations to ensure the dealings are compliant with the rules.

There are certain characteristics that help identify a spot market. These differ from the other kinds of markets that allow traders to deal in different financial instruments. Some of the features that make these markets unique are as follows:

• The price that rules the current market is the price at which the financial instruments are sold and bought in the spot market. This price is named as the spot price.
• The delivery of the financial instrument is instant and there are no delays.
• The fund transfer in exchange for the financial instruments bought is made instantly as soon as the deal is done.

Given the features of these market types, there are exceptions. For example, WTI or brent crude oil is traded at the spot price, but the delivery is done only after a month. 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 is transferred.

The spot sale and purchase occur in a cash market, which exists in different forms, thereby giving dealers and traders an opportunity to choose how they want to trade. 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. In contrast, an over the counter trade happens with a closed group of participants that does not have a central location.

Let us explore their features and uses below:

#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 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.

Let us consider the following instances to understand the spot market definition better and also check it works:

Example #1

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. Of course, 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 USD CNY rate, which is 7.03, higher than the 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 two days (T+2), and John can make the payment, which allows him 40% savings on his purchase.

Example #2

Steve is looking to invest $ 5,000 in the stock market but is unsure how he should start. He starts a Demat account with one of his trusted banks and checks into the various stocks traded over the market. Due to the fear of losing his money, Steve is interested in putting his money only into the blue-chip stocks. He buys 100 shares of Apple at $ 200.47. He makes the payment for it and hastens shares of Apple in his account; the spot market also allows immediate settlement. It allows Steve to get ownership of Apple shares on the same day. Steve also looks for other penny stocks, which he thinks might become a good performer. He invests $ 2,000 in two different penny stocks.

Now, Steve has $ 1,000, and 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 invests the remaining $ 1,000 in currency.

The trade settles in 2 days, and the account will be delivered with the Chinese Yuan.

Spot market offers multiple advantages to traders and dealers who do not want to wait for the trade to take place. The ones who want instant transactions, these markets are the best way to achieve the objective. However, along with advantages come the limitations, which the traders and dealer must be aware of before they deal in financial instruments in these markets. Learning about these limitations help the participants of these deals to understand the market with respect to the spot orders and tackle the risks efficiently.

Let us have a look at a list of pros and cons of these markets:

Benefits

• The spot market is more flexible than a futures market since they can be traded on lower volumes (1,000 units). In contrast, a futures market requires higher volumes (usually 100,000 units, except very few instruments).
• This type of market is quick, and the delivery is usually two days.
• A spot market is straightforward, unlike a futures market.
• The physical market facilitates immediate trading with a transfer of funds and ownership quickly.
• Traders most favor it due to its flexibility and ease of trading rather than the futures market, which can be complicated and time-consuming.

Limitations

• Investors might end up buying financial instruments at an inflated spot market rate because of fluctuations.
• There is no flexibility in terms of timing as the dealers and traders make everything instantly and there is no scope of delayed actions.
• In the instant dealings, there are possibilities of finding issues with the instruments bought. For such instances, spot market provides no solution, be it of refunds, returns, or exchange.
• When it comes to spot transactions of currencies, the counterparty risk involved is quite high.

A spot, futures, and forward market can be said to be the opposites. While spot transactions involve instant delivery of financial instruments, futures contract involve paying for the assets or securities beforehand, taking deliveries at a later date. Besides this, there are other differences too that one must know about them. Let us have a quick look at them below:

• 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 later 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, not immediately.
• Local regulations regulate the physical market.
• The price quoted for a purchase or sale on a spot market is the Spot Price.

The forward market might sound similar to futures market as they both deliver the bought instruments to the buyer at a future date, it must be noted that for the former, the price is determined only when the contract is drawn up. Additionally, a forward market orders also have significant differences with spot orders.

Let us have a look at the difference between spot rate and forward rate below:

• The delivery of the financial instrument is done on the spot, i.e., immediately in the spot market, while the delivery is done at a future date in case of the forward counterpart.
• The spot transactions take a maximum of T+2 days to settle, while the settlement date of all the forward transactions is one and that is after the end of the agreement or forward contract.
• While the former is an instant decision that might make buyers end up paying more for a financial instrument, the latter gives investors an opportunity to tackle the volatility witnessed in an asset’s price.

This article has been a guide to what is spot market. We compare it with forward market & explain its examples, vs futures market, features, types, advantages, and advantages. You can learn more about financing from the following articles –

• Forward Market
• OTC Market
• Spot Rate
• Share Market