What Is a Cash Market?
A cash market is a marketplace in which the commodities or securities purchased are paid for and received at the point of sale. For example, a stock exchange is a cash market because investors receive shares immediately in exchange for cash.
Cash markets are also known as spot markets, because their transactions are settled "on the spot." The opposite of a cash market is a futures market, where buyers pay for the right to receive a good, such as a barrel of oil, at a specified date in the future.
- In a cash market, investors take possession of goods at the point of sale.
- They are the opposite of a futures market, in which investors purchase the right to take possession at some future date.
- Stock exchanges are primarily cash markets, because shares are exchanged for cash at the point of sale.
Understanding Cash Markets
Cash markets can take place either on a regulated exchange, such as a stock market, or in relatively unregulated over-the-counter (OTC) transactions. While regulated exchanges offer institutional protections that can protect against counterparty risks, OTC markets allow the parties involved to customize their contracts. Futures markets are conducted exclusively on exchanges, while forward contracts—typically used in foreign exchange transactions—are traded on OTC markets.
Sometimes, the line between cash markets and futures markets can get blurred. For example, stock exchanges like the New York Stock Exchange (NYSE) are mostly cash markets, but they also facilitate trading of derivative products which are not settled on the spot. Therefore, depending on the underlying assets being traded, the NYSE and other exchanges can also operate as a futures market.
Whether an investor chooses to transact on a cash market or a futures market will depend on their unique needs. For example, an industrial company that needs oil to fuel its production processes might purchase barrels of oil on a cash market and take physical delivery at the point of sale. By contrast, that same company might wish to hedge against the risk that oil prices will rise in the following years. To do so, it might purchase futures contracts for oil, in which case no physical barrels of oil would exchange hands at the time of sale.
In deciding between cash and futures markets, investors will also consider the costs of transacting in each marketplace. For most commodities, the cost of purchasing that commodity in the spot market is lower than its cost in the futures market. This is because there are costs associated with taking physical possession of the commodity, such as storage costs and insurance.
Although a vast amount of transactions take place on cash markets worldwide, a far larger quantity of transactions take place on futures markets. This is mainly due to the various derivative markets, which have become increasingly large and liquid in recent years.
Real World Example of a Cash Market
ABC Foods is a manufacturing company that uses wheat in several of its food products. Rather than cultivating wheat directly, ABC relies on the cash market to provide its wheat supplies. To do so, it purchases large amounts of wheat each month from farmers, paying for those goods in cash and stockpiling them in its warehouses.
In addition to its cash-market purchases, ABC also uses forward contracts to secure the right to purchase wheat at predetermined prices in the future. In these situations, ABC does not take possession of the wheat at the point of sale. These transactions take place on an OTC basis between ABC and a specific counterparty, such as a food broker or a specific wheat producer.