Spot, forward and futures markets
The spot market is where financial instruments, such as commodities, currencies, and securities, are traded for immediate delivery. Delivery is the exchange of cash for a financial instrument.
Forward and futures are Based on the delivery of the underlying asset at a future date.
A forward contract is a private and customizable agreement that settles at the end of the agreement and is traded over-the-counter.
A futures contract has standardized terms and is traded on an exchange, where prices are settled on a daily basis until the end of the contract.
Spot Market:
- Financial instruments trade for immediate delivery in the spot market
- Most spot market transactions have a T+2 settlement date
- Spot market transactions can take place on an exchange or over-the-counter (OTC).
- Spot markets can be contrasted with derivatives markets that instead trade in forwards, futures, or options contracts
Pros:
- Real-time prices of actual market prices
- Active and liquid markets
- Can take immediate delivery if desired
Cons:
- Must take physical delivery in many cases
- Not suited for hedging
Forward Contracts
- The forward contract is an agreement between a buyer and seller to trade an asset at a future date
- The price of the asset is set when the contract is drawn up
- Forward contracts have one settlement date—they all settle at the end of the contract
- Many hedgers use forward contracts to cut down on the volatility of an asset's price. Since the terms of the agreement are set when the contract is executed, a forward contract is not subject to price fluctuations. So, if two parties agree to the sale of 1,000 ears of corn at $1 each (for a total of $1,000), the terms cannot change even if the price of corn goes down to 50 cents per ear. It also ensures that delivery of the asset, or, if specified, cash settlement, will usually take place.
Futures Contracts
Like forward contracts, futures contracts involve the agreement to buy and sell an asset at a specific price at a future date
The futures contract, however, has some differences from the forward contract
- Futures contracts—also known as futures—are marked-to-market daily, which means that daily changes are settled day by day until the end of the contract. Furthermore, a settlement for futures contracts can occur over a range of dates.
- Because they are traded on an exchange, they have clearinghouse that guarantees the transactions. This drastically lowers the probability of default to almost never. Contracts are available on stock exchange indexes, commodities, and currencies. The most popular assets for futures contracts include crops like wheat and corn, and oil and gas.
- The market for futures contracts is highly liquid, giving investors the ability to enter and exit whenever they choose to do so.
- These contracts are frequently used by speculators, who bet on the direction in which an asset's price will move, they are usually closed out prior to maturity delivery usually never happens. In this case, a cash settlement usually takes place.
So, these are the main differences between spot, forward and futures markets and contracts.