What Is a Cash Contract?
A cash contract is a financial agreement in which one party agrees to purchase a specified quantity of a commodity on a predetermined date. Unlike futures contracts in which the purchaser often closes out their contract for cash prior to the delivery date, the buyer in a cash contract always intends to take physical delivery of the commodity.
Cash contracts are common among industrial customers that rely on commodities for their production processes. By contrast, futures contracts are often used by financial speculators or traders who wish to hedge risks or speculate on price movements.
- Cash contracts are by buyers who wish to purchase and take physical delivery of commodities.
- Industrial customers use cash contracts, particularly to meet their short-term supply needs.
- They are sometimes used in combination with futures contracts and over-the-counter (OTC) transactions.
How a Cash Contract Works
Cash contracts are regularly entered into through the spot markets of various commodities. Large manufacturers regularly rely on these markets to purchase vital commodities, such as raw materials for their factories, fuel for their vehicles, and electricity to power their facilities and machines. These manufacturers are not speculating on the price of the commodities they need, which can be done in the futures market. Instead, they are physically purchasing the raw materials they need for their daily operations.
In addition to purchasing these commodities directly through spot markets, another way for companies to enter into cash contracts is through the over-the-counter (OTC) market. In OTC transactions, the buyer will enter into a cash contract directly with a specific counterparty, as opposed to relying on a third-party commodities exchange or clearinghouse. The advantage of OTC transactions is that they can be highly customized, whereas exchange-based transactions rely on standardized contracts. Their main drawback, however, is that they can entail greater counterparty risk.
In practice, a purchaser might rely on a mixture of these methods when purchasing commodities. For example, a company might use cash contracts in the spot market to fulfill most of their short-term supply needs, especially when the commodities involved do not require customization. When non-standard delivery times, commodity types, or quantity types are required, the buyer can rely on the OTC market. And lastly, when engaging in risk hedging, speculation, or simply planning farther in advance, buyers can rely on commodity futures.
Real World Example of a Cash Contract
To illustrate, consider the case of a hypothetical coffee products manufacturer called ABC Coffee. To produce its product line, ABC must ensure that it has a steady supply of coffee beans. To achieve this goal, ABC purchases its commodities using three basic methods: cash contracts, futures contract, and OTC purchases.
ABC relies on cash contracts to supply most of its coffee beans, paying in cash for specified quantities of beans and taking delivery of them within a few days of the purchase. When making these purchases, ABC accepts the latest spot price of the beans.
In times when ABC wants to plan farther into the future, it can use coffee bean futures contracts to lock in a longer-term supply. This method of using futures contracts is especially attractive when ABC is concerned that the price of coffee beans might rise during the forecasted period, because the futures allow ABC to lock in a known price today for several months’ supply of beans.
Lastly, ABC can use OTC contracts when it needs to source coffee beans or other commodities that fall outside of the standardized quantities, delivery times, or commodity types offered by the spot and futures markets.