1.2.2. Cash, Forward, and Futures Markets
Commodities (e.g., butter, gold) and financial products (e.g., interest rates, stock indices) may be bought and sold in either the cash market or the forward and futures markets. In the cash market, also called the spot market, products are bought or sold at today’s prevailing market prices. A transaction in the cash market always involves the physical exchange of the product at terms and conditions that the buyer and seller negotiate together.
In the forward market, two parties privately negotiate the terms and conditions of the forward contract, just as in the spot market. However, the price of the product is based, not on today’s spot market prices, but on today’s expectations of prices at some point in the future. With the forward market, delivery of the product is generally expected upon the contract’s completion, but the contract may settle financially by paying the contract value of the product instead.
Because a forward contract is negotiated privately, the parties are exposed to the risk that one of them will not live up to its terms and default on the contract. This is known as counterparty risk. In addition, the forward market mostly deals in large transaction sizes. A smaller investor may not have the resources to scour the forward market and locate the best buyer or seller for his product. What the forward market offers is flexibility. The delivered product may be of any quality or amount. Delivery may be made wherever and whenever the parties decide. It does not have to be some designated area on a designated day or month, as required by a commodities exchange. Finally, forward contracts are traded publicly in the unregulated market, known as the over-the-counter market.
With a futures contract, only the quantity of the product and its price are left to the discretion of the parties. All other terms and conditions are designated by a third party known as a futures exchange. All futures